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What Is Inventory Turnover Ratio
The inventory turnover ratio is a financial measure allowing a company to calculate how many times it was able to sell and replenish its inventory within a given period of time.
For instance, if a company has a turnover ratio of 2 in a one-month period, it means that it was able to sell and replace its inventory two times in one month.
A company should calculate its inventory turnover ratio so that it can make better financial decisions such as when to purchase additional inventory, how much to buy, at what price, and so on.
When a company has a high turnover ratio, it has strong sales and can sell its inventory and replace it quickly.
On the other hand, a company with a low inventory turnover ratio may not have high sales and could potentially carry excess inventory that it cannot liquidate.
Inventory Turnover Ratio Formula
To calculate the inventory turnover ratio, you can use the following formula:
Inventory Turnover Ratio = Cost of Goods Sold / Average Value of Inventory
The cost of goods sold is a figure that you can get from a company’s income statement.
It represents the total cost to a company to produce its goods.
The average inventory value is the beginning value of your inventory plus the ending value of your inventory divided by two.
Another formula you can use to calculate inventory turnover ratio is:
Inventory Turnover Ratio = Sales / Average Inventory
The first formula can provide you with a slightly more accurate ratio.
Typically, sales figures will include things like price markups that may impact your inventory turnover ratio.
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Inventory Turnover Ratio Interpretation
The reason why you want to calculate the inventory turnover ratio is that you want to know how fast is a company able to sell and replace its inventory in a given period of time.
The faster a company is able to go through its inventory, you are able to conclude that the company has strong sales.
However, if the company is unable to replace its inventory fast enough to cover its strong sales, there may be issues with the replenishment of inventory or the company may not be operating at optimum efficiency.
A low inventory turnover ratio means that a company does not have strong sales and that it may be sitting on excess inventory.
There could be several causes for a low inventory turnover ratio such as weak sales, inappropriate marketing, overstocking, or other potential issues.
Companies with a higher inventory turnover ratio tend to perform better than those with lower ratios.
When a company is able to quickly sell through its inventory, it is able to quickly turn its inventory into cash, it is able to reduce its inventory carrying costs, and can lower risk in market shifts impacting its ability to sell its inventory.
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Inventory Turnover Ratio vs Days Sales of Inventory
What is the difference between inventory turnover ratio and days sales of inventory?
The inventory turnover ratio is a financial measure to assess how fast a company is able to sell the content of its inventory.
On the other hand, days sales of inventory is a measure to see how long it takes for a company to convert its inventory into sales.
You calculate days sales of inventory by taking your inventory, divided by the cost of goods sold, and the result multiplied by 365.
The idea is to see how many days it takes for your inventory to convert into sales.
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Inventory Turnover Ratio Example
Let’s look at an example of inventory turnover ratio to illustrate the concept better.
Let’s assume a company has the following financial characteristics:
- Cost of goods sold of $750,000
- Average inventory of $50,000
Now, this company’s inventory turnover ratio is cost of goods sold ($750,000) divided by average inventory ($50,000), giving us a ratio of 15.
This means that the company is able to turn over its inventory 15 times in a one-year period.
If the companies in the same industry have an average inventory turnover ratio of 50, the figures for this company can raise some flags where it appears that the company is not turning over its inventory as fast as its peers.
This can mean the company has overstocked, has weaker sales than its peers, or may have issues properly stocking its inventory.
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Inventory Turnover Ratio FAQ
What does inventory turnover mean?
The inventory turnover ratio is a measure of how many times a company was able to sell and then replace its inventory over a period of time.
This is an important financial metric as it provides you with a direct measure of the relationship between your inventory and your sales.
What is a good inventory turnover ratio?
Like many other financial ratios, it’s difficult to come up with a cookie-cutter answer to say what is good and what is not.
To assess what is a good inventory turnover ratio, a company can look at its peers, look at its own internal data, and evaluate the ratio over time.
A company that is above industry average is potentially showing a good inventory turnover ratio.
Also, if you are seeing an increase in your inventory turnover ratio over the years, it means that you are managing your inventory more efficiently.
What does a high or low inventory turnover ratio mean?
A high turnover ratio means that a company can sell and replace its inventory more often in a given period.
For the turnover ratio to be high, the company should have a high sales volume allowing it to liquidate its inventory quickly.
A low inventory turnover ratio means that it takes more time for a company to acquire and sell items in its inventory.
This means that the company may have a lower sales volume and will have to carry the content of its inventory longer.
It can also mean that the company is not efficiently managing its inventory.
How to improve inventory turnover ratio?
There are many ways you can improve your inventory turnover ratio, such as:
- Invest in marketing
- Review your pricing strategy on a regular basis
- Use an inventory management system
- Carry products that sell more
- Automate your inventory control
- Purchase inventory strategically
How do you calculate inventory turnover ratio?
You’ll need to follow these steps to calculate your inventory turnover ratio:
Step 1: identify your cost of goods sold for a given accounting period
Step 2: determine your average inventory by finding your beginning and ending inventory values.
Step 3: calculate your average inventory value by taking the beginning value, adding the ending value, and dividing by two.
Step 4: Divide your cost of goods sold by the average inventory value.
Takeaways
So there you have it folks!
What is the inventory turnover ratio?
In a nutshell, the inventory turnover ratio is a financial ratio allowing you to see how efficiently a company manages its inventory by calculating how many times it sells and replaces its inventory in a given period.
In other words, the idea is to see how many times the company is able to “turn over” its inventory.
The inventory turnover ratio can tell you if a company has strong or weak sales, if it is carrying excess inventory or not, and how efficiently its inventory is managed.
Companies with higher turnover ratios typically outperform other companies as they have stronger sales, do not risk ending up with dead or obsolete stock, have lower holding costs, and so on.
Now that you know what inventory turnover ratio is and how it works, good luck with your research!
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