Inventory Turnover

The speed at which a business sells its inventory

What is Inventory Turnover?

Inventory turnover is the number of times a business sells and replaces its stock of goods during a given period. It considers the cost of goods sold, relative to its average inventory for a year or in any a set period of time.

A high inventory turnover generally means that goods are sold faster and a low turnover indicates weak sales and excess inventories which may be challenging for a business.

Inventory turnover can be compared to historical ratios, planned ratios, and industry averages to assess competitiveness and intra-industry performance.  Inventory turns can vary significantly by industry.

 

inventory turnover counting

 

How to Calculate Inventory Turnover Ratio?

Inventory Turnover Ratio =   (Cost of Goods Sold)/(Average Inventory)      

For example:
Republican Manufacturing Co. has a cost of goods sold worth $5M for the current year. The company’s cost of beginning inventory was $600,000 and cost of ending inventory was $400,000. Given the inventory balances, the average cost of inventory during the year is calculated at $500,000. As a result, inventory turnover is rated at 10 times a year.

 

What is Cost of Goods Sold?

Cost of goods sold is an expense incurred from directly creating a product, including, the raw materials and labor costs applied to it. However, in a merchandising business, the cost incurred is usually the actual amount of the finished product (plus shipping cost if any if applicable) purchased paid for by a merchandiser from a manufacturer or supplier.

In both types of businesses, the cost of sales is properly determined by using an inventory account or list of raw materials or goods purchased, maintained by the owner of the company.

 

What is Average Inventory?

Average inventory is the average cost of a set of goods during two or more specified time periods. It takes into account the beginning inventory balance at the start of the fiscal year plus the ending inventory balance of the same year.

These two account balances are then divided in half to obtain the average cost of goods resulting in sales.

Average inventory does not have to be computed on a yearly basis; it may be on a monthly or quarterly, depending on the amount of analysis required to assess the inventory account.

 

Turnover Days in financial modeling

Below is an example of calculating the inventory turnover days in a financial mode.  As you can see in the screenshot, the 2015 inventory turnover is 73 days, which is equal to accounts receivable divided by cost of goods sold times 365.

 

Inventory turnover in a financial model

Source: CFI financial modeling courses.

 

Importance of Inventory Turnover for a Business

One way to assess business performance is to know how fast inventory sells and, how it meets the market demand, and how its sales stack up to other products in its class category. Businesses rely on inventory turnover to evaluate product effectiveness, as this is the business’s primary source of revenue to survive the operations.

Higher stock turns are favorable because they imply product marketability and reduce holding costs, such as rent, utilities, insurance, theft, and other costs of maintaining goods.

Another purpose of inventory turnover is in to compare a business with other businesses in the same industry. Companies gauge their operational efficiency based upon whether their inventory turnover is at par with or surpasses the average benchmark set, as per industry standards.

 

Additional resources

Thank you for reading this guide to better evaluating how inventory turns at a company. To keep learning and advancing your career as a financial analyst, these additional resources will help you:

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