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Inventory Turnover

Guide to Understanding the Inventory Turnover Ratio

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Inventory Turnover

How to Calculate Inventory Turnover Ratio (Step-by-Step)

The inventory turnover ratio portrays the efficiency at which the inventory of a company is turned into finished goods and sold to customers. In other words, the ratio measures how well a company can convert its inventory purchases into revenue.

The ratio is calculated by dividing the cost of goods sold (COGS) by the average inventory balance for the matching period. Thus, the metric determines how long it takes for a company to sell its entire inventory (and need to place more orders).

The steps for calculating the ratio are the following:

  • Step 1 → Calculate the average inventory by adding the prior period inventory balance and ending inventory and then dividing by two.
  • Step 2 → Divide the numerator, the cost of goods sold (COGS) in the corresponding period, by the average inventory as calculated above.

Inventory Turnover Formula

The formula used to calculate a company’s inventory turnover ratio is as follows.

Inventory Turnover Ratio = Cost of Goods Sold (COGS) ÷ Average Inventory

While COGS is pulled from the income statement, the inventory balance comes from the balance sheet.

In effect, a mismatch is created between the numerator and denominator in terms of the time period covered.

  • Income Statement → The financial performance, such as revenue, costs, and profitability, of a company across two periods.
  • Balance Sheet → A “snapshot” at a specific point in time of a company’s assets, liabilities and equity.

Comparing a company’s ratio to its industry peer group can provide insights into how effective management is at inventory management.

Some examples of practical diligence questions to ask (or answer) from assessing a company’s inventory management are the following:

  • Is the company pricing its products at a competitive rate where there is sufficient customer demand?
  • Does the revenue generated from the sale of proceeds offset the expenses to be profitable?
  • Have recent purchases referenced historical customer demand patterns?
  • Which specific products have been selling out quickly and causing lost revenue (and vice versa)?
  • Are there any specific products that have lost a substantial amount of consumer demand as of late?

Inventory Turnover Ratio vs. Days Inventory Outstanding (DIO)

The turnover of inventory ratio is closely tied to the days inventory outstanding (DIO) metric, which measures the number of days needed by a company to sell off its inventory in its entirety.

The relationship between the two is as follows:

Days Inventory Outstanding (DIO) = 365 Days ÷ Inventory Turnover

Unique to days inventory outstanding (DIO), most companies strive to minimize the DIO, as that means inventory sits in their possession for a shorter period of time.

How to Interpret Inventory Turnover Ratio (Industry Benchmarks)

Since the turnover ratio represents the number of times that a company clears out its entire inventory balance across a defined period, higher turnover ratios are preferred.

  • High Turnover Ratio → The company likely experiences strong demand in the market for its products.
  • Low Turnover Ratio → There might be poor demand in the market and excess inventory accumulating (i.e. overstocking).

The company’s inventory, if left unsold, might eventually need to be written down to reflect the true (lower) value on the balance sheet.

For companies with low turnover ratios, the duration between when the inventory is purchased, produced/manufactured into a finished good, and then sold is more prolonged (i.e. requires more time).

That said, low turnover ratios suggest lackluster demand from customers and the build-up of excess inventory.

Retailers are typically known for exhibiting high turnover ratios – in particular, “fast-fashion” retailers like Zara are highly regarded for their ability to research trends and clear out their inventory quickly.

Caveat to High Turnover Ratio

If a company’s inventory has an abnormally high turnover, it could also be a sign that management is ordering inadequate inventory as opposed to managing inventory well.

In such cases, the amount of pent-up demand (i.e. back orders, delayed deliveries, and speed) must be evaluated to understand the reality of the circumstances, as well as if there is an adverse impact on revenue.

Rather than being a positive sign, high turnover could mean that the company is missing out on potential sales due to insufficient inventory.

Inventory Turnover Calculator – Excel Model Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Inventory Turnover Ratio Calculation Example

Suppose a retail company has the following income statement and balance sheet data.

  • Cost of Goods Sold (COGS) = $100,000
  • Beginning Inventory = $60,000
  • Ending Inventory = $40,000

For 2021, the company’s inventory turnover ratio comes out to 2.0x, which indicates that the company has sold off its entire average inventory approximately 2.0 times across the period.

  • $100,000 / Average ($60,000, $40,000) = 2.0x

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calcuing
calcuing
February 22, 2022 7:05 am

Income ratio is a metric used to measure the ability of a technology to recover the investment costs through savings achieved from customer utility bill cost reduction. The ratio divides the “savings” by the “investment”; an SIR score above 1 indicates that a household can recover the investment.

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