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Inventory Turnover

Understand the Inventory Turnover Concept

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Inventory Turnover

In This Article
  • What is the meaning of inventory turnover?
  • How is the inventory turnover ratio calculated?
  • What is a good inventory turnover ratio?
  • How is the inventory turnover different from days inventory outstanding (DIO)?

Inventory Turnover Formula

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, inventory turnover measures how well a company can convert its inventory purchases into revenue.

The formula for calculating inventory turnover figures out how long it takes for a company to sell its entire inventory (and need to place more orders).

The ratio is calculated by dividing the cost of goods sold (COGS) by the average inventory balance for the matching period.

Inventory Turnover = COGS / Average Inventory

The steps for calculating the inventory turnover ratio are:

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

The inventory turnover ratio when compared against that of industry peers and averages can provide insights into how effective management is at inventory management.

Inventory Turnover Insights
  • 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)?

High vs Low Inventory Turnover

The inventory turnover equals the number of times that a company clears out its entire inventory balance across a defined period, so higher turnover ratios are preferred.

  • If a company has a high inventory turnover, that typically means the company experiences strong demand in the market for its products.
  • By contrast, a low inventory turnover means 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 inventory 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 inventory turnover ratios suggest lackluster demand from customers and the build-up of excess inventory.

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

High Inventory Turnover Caveat

If a company has an abnormally high inventory 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 inventory turnover could mean that the company is missing out on potential sales due to insufficient inventory.

Inventory Turnover Example Calculation

Let’s say that a retail company has the following income statement and balance sheet data.

Financial Assumptions
  • Cost of Goods Sold: $100,000
  • Beginning Inventory: $60,000
  • Ending Inventory: $20,000

The inventory turnover ratio comes out to 2.5x, which indicates that the company has sold off its entire average inventory approximately 2.5 times across the period.

Inventory Turnover vs Days Inventory Outstanding (DIO)

The inventory turnover 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

Unlike inventory turnover, companies strive to minimize the DIO, as that means inventory sits in their possession for a shorter period of time.

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