Inventory Turnover Ratio
The inventory turnover ratio measures the amount of times inventory is sold and replaced by a company during a specific period of time.
What is the Inventory Turnover Ratio?
The inventory turnover ratio measures the amount of times inventory is sold and replaced by a company during a specific period of time. It is one of many financial ratios that measures how efficiently management is utilizing its assets. The ratio can be used to determine production, inventory stocking, and pricing strategies in order to more effectively sell products in a timely manner.
The days in inventory– the number of days before inventory sells– can then be calculated by dividing the number of days in the period by the inventory turnover ratio. This is called the days sales in inventory (DSI).
Inventory Turnover Ratio Formula
The formula for the inventory turnover ratio is:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Value
Cost of Goods Sold
Cost of goods sold is a line item on a company’s income statement. It measures the total direct costs of producing a good or service. Direct costs include items such as labor costs and materials used in production.
Average Inventory Value
Average inventory can be calculated by taking the inventory balance on the previous and current periods’ balance sheets. Add both together and divide by two to get the average inventory value during the period. The average inventory value is used to minimize the effects of seasonal fluctuations on inventory supply.
Inventory Turnover Ratio Example
Small Town Retailer sells primarily clothing. It has $20,000 in inventory at the beginning of the year and $28,000 in inventory at the end of the year. Its cost of goods sold for the one year period was $150,000. Using the inventory turnover ratio, we can calculate:
$150,000 / [($20,000 + $28,000) / 2] = 6.25
Where:
- $150,000 = Cost of Goods Sold
- [($20,000 + $28,000) / 2] = $24,000 = Average Inventory Value
Small Town Retailer replenished and sold its entire inventory stock 6.25 times throughout the year. We can take this one step further and determine the number of days sales in inventory by dividing the number of days in the period by the inventory turnover ratio.
365 / 6.25 = 58.4
Where:
- 365 = Days in Year
- 6.25 = Inventory Turnover Ratio
Small Town Retailer turned over its entire stock of inventory approximately every 58 days.
Real Company Example: Walmart’s 2023 Inventory Turnover Ratio
Walmart has the following income statement and balance sheet details in its 2023 Annual Report. Its cost of sales– another term for cost of goods sold– is listed as $463,721 million in fiscal year 2023. Its inventory value was $56,511 as of January 31, 2022 2022 and $56,576 as of January 31, 2023.
The inventory turnover ratio can, therefore, be calculated as:
$463,721 million / [($56,511 million + $56,576 million) / 2] = 8.20
Where:
- $463,721 million = Cost of Sales / Cost of Goods Sold
- [($56,511 million + $56,576 million) / 2] = $56,543.50 = Average Inventory Value
You can also extrapolate that the number of days sales in inventory is:
365 / 8.20 = 44.51
Where:
- 365 = Days in fiscal year
- 8.20 = Inventory turnover ratio
This means that Walmart sold its entire stock of inventory approximately every 45 days in fiscal year 2023.
What is a Good Inventory Turnover Ratio?
A good inventory turnover ratio varies based on the industry, so you should only look at companies in a similar industry when comparing inventory turnover ratios. The inventory turnover ratio can also be useful when analyzing the results of a single company’s management, production, and inventory stocking methods over time. A lower inventory turnover ratio means a company has inventory for a long period of time before making a sale. That is typically not a good sign.
On the other hand, a higher inventory turnover ratio means the company is making frequent sales. This can be a good or bad sign depending on the situation. It could mean that the company has mastered its just-in-time manufacturing, or it could mean that it has an insufficient inventory stocking. If it has insufficient inventory stocking, the company may have long periods of time where inventory is backordered before a sale can be made. This means the company is losing out on sales in the meantime because of its insufficient inventory.
Just-In-Time Manufacturing
Just-in-time (JIT) manufacturing is a production strategy where the company stocks exactly the inventory necessary to meet current demand. With minimal inventory values, the inventory turnover ratio will be higher in a company that has implemented JIT manufacturing. It has the benefit of reducing storage costs for excess inventory. Direct costs from labor and material purchases are also reduced since the company is only producing the exact number of items necessary to meet demand, rather than a backlog that will sit in inventory for a while. However, the drawback to JIT manufacturing is that any hiccup in the production process will halt the sales of goods that are currently in demand.
Low Inventory Turnover Ratio Industries
Some industries expect low inventory turnover, specifically those with seasonal fluctuations or high-value or luxury items. If a Halloween retailer does not sell all of its costumes by early November, those costumes can be expected to sit in inventory in a warehouse until the following year. The items sitting in inventory for a lengthy period of time will, in turn, lower the inventory turnover ratio.
Automobile dealers may also house inventory for a longer period of time before a sale. Luxury items– like jewelry or other high profit margin businesses– may also have a low inventory turnover ratio because each sale brings in a higher dollar value to the company compared to a low profit margin business. Industries with a low inventory turnover ratio tend to have goods that do not spoil quickly.
High Inventory Turnover Ratio Industries
Grocery stores and florists are examples of industries in which you’d expect to see a high turnover. In these industries, the perishable goods need to be sold at a faster rate or the inventory will go to waste. If the stores don’t sell their products in a certain timeframe, they will lose the items to spoilage. They also typically have a lower profit margin.
Other Important Ratios
The inventory turnover ratio is often used in financial statement analysis alongside other efficiency ratios such as the accounts receivable turnover ratio (tells us how efficient a company is at collecting its receivables) and the accounts payable turnover (tells us how often a company pays its creditors during a period. These three ratios are often combined to calculate the cash conversion cycle which measures the number of days it takes a company to convert its cash investments in inventory into cash from product sales.
Additional Resources
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