How Inventory Turnover Ratio Is Calculated
Inventory turnover represents the number of times a company sells its inventory and replaces it with the new stock over the course of a certain time period, such as a quarter or year. The ratio result can tell you how effectively the company sells and how well it manages its costs.
A company’s inventory consists of all the goods it offers for sale. For example, a company may buy wholesale items, such as clothing or gift items, and resell them. Its entire inventory is made up of finished goods.
Manufacturing companies have an inventory made up of raw goods, or various product components, works in progress, and finished items. For example, the leather pieces used to make boots would be inventory for a boot maker. All of these units qualify as inventory and are recorded in inventory and work-in-progress accounts that show up as assets on the company’s balance sheet.
The Inventory Turnover Ratio
The inventory turnover ratio is an important financial ratio for many companies. Of all the asset-management ratios, it gives the business owner some of the most important financial information, by showing how many times the company turns its inventory over within the given period.
The inventory turnover ratio measures the efficiency of the business in managing and selling its inventory in a timely manner. This ratio gauges the liquidity of the firm's inventory and also helps the business owners determine how they can increase sales through inventory control.
Use either of the following formulas for the inventory turnover ratio:
Net Sales / Average Inventory = # of times turned over
Cost of Goods Sold / Average Inventory = # of times turned over
In order to calculate the ratio, use the figure for net sales or cost of goods sold from the company's income statement and inventory from its balance sheet. Cost of goods sold includes the cost of raw materials, plus the cost of any direct labor or direct factory overhead to produce the inventory goods for sale.
Many analysts use an average inventory number to account for seasonality. For example, some companies may sell more during the last three months of the year because of the holiday season, so they would average inventory using balances at different points of the year rather than just using year-end inventory.
Interpreting the Result
High turnover ratio. Generally, companies want a high inventory ratio because it indicates that the company is efficiently managing and selling their inventory. The faster the inventory sells, the smaller the amount of funds the company has tied up in inventory, and the higher sales level and corresponding profits it achieves.
Companies with a high inventory turnover must be very diligent about reordering to prevent stockouts. If the company’s turnover ratio is too high, it means it sells out too fast and might be missing out on sales because it can’t keep items in stock. This could reveal an opportunity for a price increase due to high demand.
Low ratio result. A company with a low inventory turnover ratio may be holding obsolete or slow-moving inventory that is difficult to sell or has low demand. This ties up the company’s capital and eats into its profit, especially if the company relies too much on discounting in attempts to stimulate sales.
However, the company may also be holding a lot of inventory for legitimate reasons. A retailer could be preparing for a holiday season; on the other hand, perhaps its suppliers are planning a strike or long holiday—such as for Chinese New Year when Chinese factories completely shut for almost a full month.
The Ratio and Efficiency
An efficiently run company would want to synchronize its sales and inventory levels as much as possible. Too little inventory means lost sales, while too much inventory means tied-up capital for inventory that’s not selling fast enough.
If the company’s cost of goods is out of line with inventory turnover, it might be spending too much to produce units of inventory that don’t sell quickly enough.
The inventory turnover ratio—especially when compared to historical periods, or to the same ratio from the company’s peers or competition—can tell a lot about the effectiveness of the company’s sales and purchasing teams.
Ultimately, business owners should understand why their company’s inventory turnover ratio is high or low and take action where needed. Looking at the company's investment in inventory and determining, by product or product group, which inventory is turning over the quickest with the highest profit can help identify the products to keep stocking and those to discontinue.