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What Is the Inventory Turnover Ratio?
The inventory turnover ratio indicates to an investor how often a company sells its inventory, meaning how fast product moves off the shelves. Businesses use the inventory turnover ratio to help with pricing, manufacturing, and purchasing inventory. It is an efficiency ratio that helps a company measure its ability to use assets to generate income.
Inventory Turnover Formula
The inventory ratio uses the cost of goods sold (COGS) and average inventory value to get the ratio. In the formula, the COGS is divided by the average inventory to determine how many times the inventory was turned over. The data is derived from the financial statements of the company. COGS are found on the income statement, and the average inventory will be found on the balance sheet.
Inventory Turnover Ratio = COGS / Average Inventory
Where:
- Cost of Goods: The production costs of goods sold. A company manufacturing its own products would include materials and labor. For a company reselling items, the COGS is the wholesale cost of goods.
- Average Inventory: This is the average value of the inventory for a given period of time. One method is to take inventory at the end of every month and then divide the sum by 12 to approximate an average. Many analysis just take the beginning of year inventory and end of year inventory found on the balance sheet, and judge the midpoint as the average.
Important: Estimating average inventory using the midpoint of the beginning of year and end of year inventory may deliver a misleading result for companies whose sales have seasonal patterns. Consider, for instance, a farm equipment seller that may carry much smaller inventory during the winter months.
Interpreting the Turnover Ratio
The inventory turnover ratio says a lot about a business's sales and whether it is doing a good job selecting and marketing products.
- A high turnover ratio suggests that the company has high sales and has products that are in demand and being purchased regularly.
- A low or slow inventory ratio is a negative indicator that suggests weak sales or an inventory problem. A company with weak sales may have difficulty moving inventory and may be left with overstock issues or dead stock that isn’t selling.
Tip: Companies that are moving a lot of product are generally thought to be in a better financial position than those not moving product. But this is just one indicator among many that investors should use when considering a stock purchase.
How To Calculate Inventory Turnover: Example
An example will help show how the inventory ratio is calculated. Take XYZ fictional company with $500,000 in COGS and $100,000 in average inventory. Using the formula for inventory ratio, divide the COGS by the average inventory. The inventory ratio is 5.
$500,000 / $100,000 = 5
Then, to get an idea of how often inventory needs to be replaced, divide the ratio into the time period (usually 365 days). Doing so tells us that the inventory is on hand for an average of 73 days.
365 / 5 = 73 days
Tip: The less time the inventory is on hand, the better this indicator is when reviewing a company’s strengths and weaknesses.
Why It’s Important for Investors
The inventory turnover ratio is important to investors because it indicates how often goods are sold. Investors usually prefer companies with high turnover ratios because it means that the company is selling a lot of product and needs to replace it often. Ultimately, the turnover ratio tells investors whether or not a company is effective in converting inventory into sales. This suggests a strong business model with good products, marketing, and sales practices.
How To Find Inventory Turnover
Investors looking to find the inventory turnover ratio may not find it directly from the company’s public data. Still, investors can often calculate it using the publicly available reports. Remember that COGS is found on the income statement and inventory is found on the balance sheet. Investors will divide the COGS by average inventory to determine the inventory turnover ratio.
