How to Calculate Inventory Turnover/Turns From the Balance Sheet
The lifeblood of a business involves cash flow and Inventory, and keeping them moving goes a long way towards a company's profitability and longevity. You can calculate a financial ratio, called inventory turnover, also known as inventory turns, to give you insight into the efficiency a company has, both absolute and relative when converting its cash into sales and profits. For example, let's say two different companies each have $20 million in inventory, but one sells all of it every 30 days, while the other takes 90 days to do the same.This tells you the first company has better cash flow and less risk than the second company.
The faster inventory turnover occurs, the more efficiently the business operates, and the higher return a company experiences on its equity and other assets as well.
The Formula for Calculating the Inventory Turnover Ratio
Inventory Turnover = Cost of Goods Sold / Average Inventory for the Period
Find Cost of Goods Sold (sometimes called Cost of Sales or Cost of Revenue) on a company's income statement, just under the revenue figure.
Using balance sheets from two different periods, calculate average inventory by taking the last period's inventory balance plus the current period inventory balance, then divide them by two.
Some analysts use an alternate formula of (total annual sales / average inventory) instead of the cost of sales when calculating the inventory turnover ratio. The cost of sales more accurately reflects inventory turns because it uses the actual cost of inventory. The sales figure includes the company's markup, and mathematically, your inventory turns calculation would come out different, possibly making the company look as if it was turning its inventory faster than in reality.
When using the inventory turns ratio to compare companies within an industry, make sure you're using ratios calculated on the same basis. If you assess one company using the cost of sales in the calculation, and another using total sales, you'll have an inconsistent and faulty comparison.
What's a Normal Inventory Turnover Ratio?
Comparing the inventory turnover rate of a company against that of its competitors gives insight into the efficiency of each company's management team to manage inventory and use it to generate sales, although the number of days it takes for a company to sell through its inventory varies greatly by industry.
Retail stores and grocery chains typically have a much higher inventory turn rate since they sell lower-cost products that spoil quickly, requiring far greater managerial diligence. Companies that manufacture heavy machinery, such as airplanes, will have a much lower turnover rate since each of product may sell for millions of dollars and take an extended period of time to produce and sell. Hardware companies may turn their inventory three or four times a year, while a department store may turn their inventory over six or seven times per year.
A Real World Example: The Coca-Cola Company
On Coca-Cola's historical income statement from 2017, the cost of goods sold was $13.256 million. Coca-Cola's average inventory value between 2016 and 2017 was $2.665 million, found by calculating the average of the balance sheet inventory from two points in time, 2016 and 2017, by summing the two inventory values together then dividing by two. Plug these numbers into the ratio formula for inventory turns:
Cost of Goods Sold of $13.256 million / Average Inventory of $2.665 million = 4.974 inventory turns per year
Interpreting the Answer
The ratio result tells you that Coca-Cola sold all of its inventory 4.974 times between 2016 and 2017.
Compare this to the average inventory turns of Coke's competitors to understand whether Coca-Cola's doing well. Upon researching, you might find that the average inventory turns for a company in Coke's industry was 8.4 annually, meaning they're selling the product more quickly than Coca-Cola throughout the year.
Why might Coca-Cola have a lower inventory turn rate? The answer usually involves several different business reasons, making it important to read the company's financial statements and accompanying disclosure notes. You might find that although Coke's inventory turn rate was lower, other metrics showed it was overall 4x to 5x financially stronger than the averages for its industry. With such strong economics, it's not likely the company's inventory has an issue with losing value. It's useful to also examine how the inventory turnover calculation changes for a company over a period of many years.
When analyzing a balance sheet, also look at the percentage of current assets inventory represents. If a company has 70 percent of its current assets tied up in inventory, and the business doesn't turn inventory relatively fast (less than 30 days), it may be signaling that the company has some serious issues and will need to write-down inventory as unsellable or obsolete in the near future.
Using Inventory Turnover to Calculate Average Days to Sell a Product
You can take the inventory analysis a step further for deeper insight. Once you have the inventory turn rate, you can easily calculate the number of days it takes for a business to clear its inventory. This is a ratio known as days' sales of inventory. Since a year has 365 days and Coca-Cola was clearing its inventory 4.974 times per year, we would use the following formula:
Days' sales of inventory = Inverse of inventory turns ratio * 365
Plugging in our example numbers gives the following result:
(1 / 4.974) * 365 = 73.38 days to sell Its entire inventory
While the inventory turnover ratio shows how well Coca-Cola turns its inventory of beverages and other products into sales during a given year, the days' sales ratio translates it into a daily view of the company's efficiency.