Inventory turnover is a measure of the number of times inventory is sold or used in a given period of time, such as a year. It is a good indicator of inventory quality (whether or not inventory is obsolete), efficient purchasing practices, and inventory management. This ratio is important because gross profit is earned each time inventory is turned. Also called stock turnover. This ratio is used to determine how many times a company has sold and replaced its inventory within a given period.
Inventory turnover is a key metric that helps companies manage their cash flow and working capital. It measures how quickly a company is selling its products and helps to identify any issues with inventory management. A high inventory turnover ratio indicates that a company is efficiently selling its products and is managing its inventory well, while a low ratio indicates that the company may be struggling to sell its products or is holding onto inventory for too long.
The formula for calculating inventory turnover is as follows.
Inventory Turnover Calculation (Formula)
Inventory turnover ratio is calculated by dividing the cost of goods sold by the average inventory level ((beginning inventory + ending inventory)/2):
- Cost of goods sold (COGS) refers to the direct costs associated with producing or purchasing the products that a company sells. In the income statement (statement of comprehensive income, IFRS) cost of goods sold (COGS) is named "Cost of sales".
- Average inventory is the average value of the inventory that a company holds during a given period.
For example, if a company has $1,000,000 in COGS and an average inventory value of $250,000, the inventory turnover ratio would be calculated as:
Inventory turnover = $1,000,000 / $250,000 = 4
This means that the company has sold and replaced its inventory four times during the given period.
Another approach is to divide sales (revenue) by average inventory:
The number of days in the period can then be divided by the inventory turnover formula to calculate the number of days it takes to sell the inventory on hand or "inventory turnover days":
Inventory Turnover Standards
There is no general norm for the inventory turnover ratio; it should be compared against industry averages.
A high inventory turnover ratio is generally seen as a positive sign, as it indicates that the company is efficiently managing its inventory and is selling its products quickly. However, too high an inventory turnover that is out of proportion to industry norms may suggest losses due to shortages, and poor customer-service.
On the other hand, a low inventory turnover ratio could indicate that the company is not selling its products quickly enough, resulting in excess inventory and potentially increased storage costs. It could also suggest that the company is holding onto obsolete or slow-moving inventory that may need to be written off or sold at a discount. A relatively low inventory turnover may be the result of ineffective inventory management (that is, carrying too large an inventory) and poor sales or carrying out-of-date inventory to avoid writing off inventory losses against income.
A high value for inventory turnover usually accompanies a low gross profit figure. This means that a company needs to sell a lot of items to maintain an adequate return on the capital invested in the company.
Can the inventory turnover ratio be negative?
Inventory turnover is calculated by dividing the cost of goods sold by the average inventory level for a given period. Since both the cost of goods sold and the average inventory level are positive values, inventory turnover cannot be negative. However, it is possible for a company to have a very low inventory turnover ratio, which indicates that the company is holding onto its inventory for an extended period of time.
There is our industry benchmarking calculated using US SEC data where you can find average values for inventory turnover. It is important to consider industry benchmarks when analyzing inventory turnover ratio and accounts payable turnover ratio. A company's performance should be compared to its peers in the same industry to determine how effectively it is managing its working capital. If the company's ratios are significantly different from the industry average, this could indicate that it has a competitive advantage or disadvantage in working capital management.
Formula in ReadyRatios Analysis Software
Days Inventory Outstanding = ((F1[b][Inventories]+F1[e][Inventories])/2)/( F2[CostOfSales]/NUM_DAYS)
Inventory turnover = 365 / Days Inventory Outstanding
F2 – Statement of comprehensive income (IFRS).
F1[b], F1[e] - Statement of financial position (at the [b]eginning and at the [e]nd of the analizing period).
NUM_DAYS – Number of days in the the analizing period.
365 – Days per year.
How to Improve Inventory Turnover?
Improving inventory turnover requires a company to focus on managing inventory levels effectively and ensuring that inventory is being sold quickly. Here are a few strategies that a company can use to improve its inventory turnover:
Optimize inventory levels. One of the key ways to improve inventory turnover is to optimize inventory levels. This can be achieved by improving demand forecasting, reducing lead times, and using just-in-time (JIT) inventory management techniques. By holding the right amount of inventory at the right time, a company can reduce the amount of inventory it needs to hold and improve the speed of inventory turnover.
Increase sales. Increasing sales volume can help to improve inventory turnover. A company can achieve this by expanding its customer base, launching new products or services, increasing marketing efforts, or improving the sales process. By generating more revenue, the company can sell its inventory more quickly and improve its inventory turnover.
Improve pricing strategy. Adjusting prices can help to boost sales volume and revenues, which can, in turn, improve inventory turnover. The company can consider adopting a more competitive pricing strategy, offering discounts, or introducing volume-based discounts for bulk purchases.
Liquidate slow-moving inventory. If certain inventory items are not selling or are slow-moving, it may be wise to sell them at a discount or to write them off. By reducing the amount of slow-moving inventory, the company can free up resources to invest in more profitable areas of the business.
Implement inventory management software. By using inventory management software, a company can improve its inventory tracking and forecasting, automate reordering processes, and improve the accuracy of its inventory data. This can help to reduce the amount of excess inventory and improve the speed of inventory turnover.
In order to increase inventory turnover, a business must approach inventory management holistically and concentrate on finding ways to move goods more rapidly and profitably. A business may increase its inventory turnover and become more effective and lucrative by putting these tactics into practice.
How to analyze inventory turnover ratio in conjunction with accounts payable turnover ratio?
Compare the two ratios over time: By comparing inventory turnover ratio and accounts payable turnover ratio over time, you can identify trends and patterns that may indicate areas where the company's working capital management could be improved. For example, if the inventory turnover ratio is decreasing while the accounts payable turnover ratio is increasing, this could indicate that the company is holding too much inventory, which is tying up working capital.
Calculate the cash conversion cycle: The cash conversion cycle (CCC) is a measure of how long it takes for a company to convert its investments in inventory and accounts payable into cash. It is calculated by adding the days inventory outstanding (DIO) to the days payable outstanding (DPO) and subtracting the days sales outstanding (DSO). A shorter CCC indicates that a company is more efficient in managing its working capital.By analyzing inventory turnover ratio in conjunction with accounts payable turnover ratio, a company can gain a more comprehensive understanding of its working capital management and identify areas where improvements can be made.