Inventory turnover ratio is a measurement of how efficient a company is turning their inventory into sales. The ratio itself represent the number of times a company sells and replace its stock of goods during a given period. It is used as a measurement to see if a business has an excessive inventory compared with its sales level. This is because the cost associated with managing and storing excess inventory and not producing sales is considered as inefficient and costly. The inventory turnover ratio is calculated for a given period of time, usually a mont or over a year.
There are few different formulas to calculate inventory turnover ratio of a company. Usually is calculated as cost of goods sold divided by average inventory for the period.
Inventory Turnover Ratio = Cost of Goods sold / Average Inventory
We use average inventory instead of ending inventory because many companies inventory and sales fluctuate over the year, depending on the seasonality of the business. Average inventory is usually calculated by adding the beginning and ending inventory and dividing by two. The cost of goods sold can be found on the income statement.
Let’s look at example of inventory turnover calculation. If for a given period of one year, a company has cost of good sold of $720,000 and the inventory at he beginning of the year was $100,000 and at the end of the year it was $130,000 let’s calculate the inventory turnover. First we need to calculate the average inventory lie this: The beginning inventory + the ending inventory)/2 = ($110,000 + $130,000)/2 = $240,000/2 = $120,000
Using the inventory turnover ratio formula from above we can calculate the ratio as follows:
Inventory ratio = Cost of Goods Sold / Average Inventories Or, Inventory ratio= $720,000 / $120,000 = 6
Inventory turnover ratio is an efficiency measurement and therefore a high inventory turnover generally means that goods are sold faster and that there is a demand for its products. Low turnover ratio indicates weak sales and excess inventories which may be inefficient for a business. Inventory turnover provides insight as to whether a company is managing its stock properly and planing its production and sales volume accordingly. If a company overestimate the demand for its products it might over produce and and create excessive amount of inventory that it might take a lot longer to sale. To analyse inventory turnover an investor can compared it to historical turnover ratios, planned ITR, and industry averages to assess competitiveness and efficiency of a company. Inventory turnover ratios usually differ significantly by industry.