Inventory turnover is an efficiency ratio that shows how many times a company sells and replaces inventory in a given time period. Put simply, the ratio measures the number of times a company sold its total average inventory dollar amount during the year.
So what is business inventory? Inventory or stock of a business takes into account the finished goods ready for resale, the raw materials used in the production of the finished goods, and the goods that are still a work in progress.
For example, a bread manufacturing company's inventory will be the final bread ready for sale, raw material used to produce the bread, and the bread still in the manufacturing process.
Inventory Turnover Formula
To calculate the inventory turnover for a business or company over a particular period, you divide the cost of goods sold (COGS) by the average inventory.
Why is the average inventory used instead of ending inventory? We use the average inventory to take into account the fluctuation of stock over the year. The average gives a true reflection of stock purchased and sold within a particular time period.
Let’s say the bread manufacturing company purchased a large inventory on January 1st and used part of it for bread manufacturing, purchasing additional inventories to be used in the production process throughout the year. On December, the available inventory would not be a true reflection of its stock.
Cost of goods sold is the direct production cost and can be found on the company income statement.
Inventory Turnover Analysis
A business needs to know its inventory turnover because this measures how efficiently the company controls its merchandise. If a business purchases a large inventory of stock at the beginning of the year, this would imply that it has to sell it over the year if it wants to improve its inventory turnover ratio.
What the ratio does is show that the company does not overspend by buying too much inventory which, in turn, wastes resources because you have to store the non-saleable inventory.
Failure to do this is an indicator that profitability is being affected by inventory costs, and shows that the business is not efficient at selling the inventory it purchases.
Higher inventory turnover is a good thing for any company as it indicates how efficient it is in the production as well as management of its inventories. On the other hand, businesses with a low inventory turnover ratio (when compared to other companies in the same industry) indicate inefficiencies in the management of their inventories. It could be due to overstocking cases or just a fall in demand for their products by consumers.
Different industries have different inventory turnover ratios. For example, industries dealing with perishable goods will have a higher ratio as they record higher sales throughout the year because their value of the cost of goods sold would be higher and the average stock would be lower as they cannot store these goods for long.
On the other hand, a business that deals with non-perishable goods might have a lower inventory turnover ratio as they record less cost of goods sold and they will have a larger average stock value during a certain period.
Inventory Turnover Example
Brandon’s bread manufacturing company reported its costs of goods sold at the end of the year on its income statement amounting to $2,000,000. During the beginning of that year, its opening inventory was $3,000,000 and its ending inventory was $5,000,000.
To calculate Brandon’s bread manufacturing company inventory turnover ratio or the number of times it purchased and sold its stock, we divide the cost of goods sold by the average stock.
So, Brandon’s inventory turnover is 0.5, which means that he only sold half of his inventory during the year. This implies that it would take two years to sell his entire inventory and indicates that the company does not have very good inventory control.
Inventory Turnover Conclusion
When calculating the inventory turnover ratio for a company the below points are worth bearing in mind as a quick recap of what it is, why it’s used, and how to use it:
- Inventory turnover is an efficiency ratio that shows how many times a company sells and replaces inventory in a given time period
- To calculate the ratio, divide the cost of goods sold by the average inventory
- Average inventory is the sum of starting inventory and ending inventory divided by two
- The value of the cost of goods sold by a business is found on its income statement
- A higher inventory turnover indicates the maximum utilization of resources by a company, and a lower one indicates inefficiencies in the utilization of resources
- Like many financial ratios, comparing companies by inventory turnover is best done within the same industry
- If a business investment turnover ratio is 0.5, it means the business sold half its inventory in the year
Inventory Turnover Calculator
You can use this calculator to calculate the inventory ratio of a company by entering the values for opening inventory, ending inventory, and cost of goods sold (COGS).
FAQs
1. What is inventory turnover?
The Inventory turnover is an efficiency ratio that shows how many times a company sells and replaces inventory in each time. Put simply, the ratio measures the number of times a company sold its total average inventory dollar amount during the year.
2. How do you calculate inventory turnover?
To calculate the inventory turnover ratio, divide the cost of goods sold by the average inventory.
The formula is:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
3. Is high inventory turnover good or bad?
A high inventory turnover ratio is good because it indicates the maximum utilization of resources by a company. A low inventory turnover ratio, on the other hand, is bad because it implies inefficiencies in the utilization of resources.
4. Why does inventory turnover decrease?
There are a few reasons why inventory turnover may decrease, including:
-A company selling products that have a longer shelf life and do not need to be replaced as often
-A company has made more sales than it anticipated and has had to order more goods to keep up with demand
-The cost of goods sold has increased, resulting in a higher inventory value
5. What factors affect inventory turnover?
Factors that affect inventory turnover include:
-The type of product a company sells
-The average selling price of products
-The number of days it takes to sell products
-The amount of inventory a company carries on hand
