What is Inventory Turnover
Inventory turnover is a ratio showing how many times a company has sold and replaced inventory during a given period. A company can then divide the days in the period by the inventory turnover formula to calculate the days it takes to sell the inventory on hand. It is calculated as sales divided by average inventory. Calculating inventory turnover can help businesses make better decisions on pricing, manufacturing runs, how to leverage promotions to move excess inventory, and how and when to purchase new inventory. Inventory turnover may also be found by dividing cost of goods sold with average inventory.
Reading The Inventory Turnover
BREAKING DOWN Inventory Turnover
Inventory turnover measures how fast a company sells inventory and how analysts compare it to industry averages. Low turnover implies weak sales and possibly excess inventory, also known as overstocking. It may indicate a problem with the goods being offered for sale or be a result of too little marketing. A high ratio implies either strong sales or insufficient inventory, which leads to lost business. Sometimes, a low inventory turnover rate is a good thing, such as when prices are expected to rise (inventory pre-positioned to meet fast-rising demand) or when shortages are anticipated.
The speed at which a company can sell inventory is a critical measure of business performance. Retailers that move inventory out faster tend to outperform. The longer an item is held the higher its holding cost will be and the less reason consumers will have to return to shop for new items. A good example can be seen the fast fashion business (H&M, Zara, for example). Such companies limit runs and replace depleted inventory quickly with new items. Slow-selling items equate to higher holding costs compared to faster-selling inventory. There is also the opportunity cost of low inventory turnover; an item that takes a long time to sell prevent the placement of newer items that may sell more readily.
Inventory Turnover and Profitability
Keeping inventory turnover at a healthy level equates to steady sales and a better-performing company. Faster turnover brings down the holding costs of inventory; less is spent on rent, insurance, theft, spoilage, utilities, etc. per unit sold. Inventory turnover is one component in the calculation of return on assets — the other component is profitability. Using a technique like discounting may clear out inventory but has the effect of reducing profitability. Since the return a company makes on its assets is a function of how fast it sells inventory at a profit a high turnover means nothing unless the company is making a profit on each sale.
Inventory Turnover and Dead Stock
Inventory turnover is an especially important piece of data for maximizing efficiency in the sale of perishable and other time-sensitive goods. Some examples could be milk, eggs, produce, fast fashion, automobiles and periodicals. An overabundance of cashmere sweaters may lead to unsold inventory and lost profits, especially as seasons change and retailers restock with new, seasonal inventory. Such unsold stock is known as obsolete inventory or dead stock.
Inventory Turnover Example
Companies calculate inventory turnover as sales divided by average inventory. One can calculate average inventory as: (beginning inventory + ending inventory)/2. Using average inventory accounts for any seasonality effects on the ratio. Inventory turnover is also calculated using the cost of goods sold (COGS), which is the total cost of inventory. Analysts divide COGS by average inventory instead of sales for greater accuracy in the inventory turnover calculation because sales include a markup over cost. Dividing sales by average inventory inflates inventory turnover.
Approach 1: Sales Divided by Average Inventory: As an example, assume company A has $1 million in sales and $250,000 in COGS. The average inventory is $25,000. Using the first equation, the company has an inventory turnover of $1 million divided by $25,000 in average inventory, which equals 40 turns per year. Translate this into days by dividing 365 by inventory turns. The answer is 9.125 days. This means under the first approach, inventory turns 40 times a year and is on hand approximately nine days.
Approach 2: COGS Divided by Average Inventory: Using the second approach, inventory turnover is calculated as the cost of goods sold divided by average inventory, which in this example is $250,000 divided by $25,000, which equals 10. You can then calculate the number of inventory days by dividing 365 by 10, which is 36.5. Using the second approach, inventory turns over 10 times a year and is on hand for approximately 36 days.
The second approach gives a more accurate measure because it does not include markup. Only compare inventory turnover that uses the same approach for an apples-to-apples comparison.
Inventory Turnover Considerations
Reading inventory turnover and coming to conclusions based on it is not always so cut and dry. Here are some things to consider:
- When comparing or projecting inventory turnover one must compare similar products and businesses. For example, automobile turnover at a car dealer may turn over far slower than fast-moving cosumer goods (FMCG) sold by a supermarket (snacks, sweets, soft drinks, etc.).
- For most retailers, an ideal annual turnover rate is two to four turnovers per year. Ideally, an inventory turnover rate should match a given item's replenishment rate.
- Slow-moving inventory can lead to cash flow problems if vendors require payment before inventory has sold.
- Trying to manipulate inventory turnover with discounts or closeouts it can significantly cut into ROI and profitability.
Inventory Turnover and Open-to Buy Systems
Some retailers may employ an open-to-buy system as they seek to manage their inventories and the replenishment of their inventories more efficiently. Open-to-buy systems at their core, are software budgeting systems for purchasing merchandise. Such a system can be used to monitor merchandise and may be integrated into a retailers financing and inventory control processes. It can help small retailers to better manage decisions on how much inventory to buy, how to evaluate how inventory is performing and assist with future inventory procurement. Such software may be tailored to some degree but may not be useful for all types of merchandise. For example, it may work best with seasonal merchandise and fashion, but may not be a good fit for fast-selling consumer goods or basic items and staples.