What is the Inventory Turnover Ratio?
The inventory turnover ratio, also known as the stock turnover ratio, is an efficiency ratio that measures how efficiently inventory is managed. In other words, the inventory turnover ratio formula is equal to the cost of goods sold divided by total or average inventory to show how many times inventory is “turned” or sold during a period. The ratio can be used to determine if there are excessive inventory levels compared to sales.
Inventory Turnover Ratio Formula
The formula for calculating the ratio is as follows:
- Cost of goods sold is the costs attributed to the production of the goods that are sold by a company over a certain period. The cost of goods sold by a company can found on the company’s income statement.
- Average inventory is the mean value of inventory throughout a certain period. Note: an analyst may use either average or end-of-period inventory values.
Practical Example of Inventory Turnover Ratio
For example, Walmart Inc. (WMT) and Target Corporation reported the following figures in its financial statements:
The ratio for Walmart is calculated as follows:
Likewise, the ratio for Target is calculated as follows:
By comparing the inventory turnover ratios of Walmart and Target, two companies that operate mainly in the retail industry, we can see that Walmart sells its inventory 8.26x over a period of one year compared to Target’s 5.54x. It implies that Walmart can more efficiently sell the inventory it buys. In addition, it can show that Walmart is not overspending on inventory purchases and is not incurring high storage and holding costs compared to Target.
Interpretation of Inventory Turnover Ratio
Inventory turnover ratio is an efficiency ratio that measures how well a company can manage its inventory. It is important to achieve a high ratio as it reduces storage and other holding costs. It is vital to compare the ratios between companies operating in the same industry and not for companies operating in different industries. The benchmark inventory turnover ratio varies greatly depending on the industry.
A low inventory turnover implies that a company’s sales are poor, is carrying too much inventory, or experiencing poor inventory management. It is important to have a high inventory turnover ratio as unsold inventory can face significant risk from fluctuating market prices and obsolescence.
Depending on the industry that the company operates in, inventory can help determine its liquidity. For example, inventory is one of the biggest assets that retailers report. If a retail company reports a low inventory turnover ratio, the inventory may be obsolete for the company, resulting in lost sales and additional holding costs.
- Inventory turnover ratio is an efficiency ratio that measures how efficiently inventory is managed.
- Inventory turnover ratio should only be compared for companies operating in the same industry as the inventory turnover ratio varies greatly depending on the industry.
- A high ratio is always favorable as it reduces storage and other holding costs.
- A low ratio implies poor sales, excess inventory, or inefficient inventory management.
- Depending on the industry, the inventory turnover ratio can be used to determine a company’s liquidity.
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