What Is the Inventory Turnover Ratio?
How to Calculate the Inventory Turnover Ratio
The inventory turnover ratio is a formula that makes it easy to figure out how long it takes for a business to sell through its entire inventory. A higher inventory turnover ratio usually indicates that a business has strong sales compared to a company with a lower inventory turnover ratio.
Learn how to calculate this ratio and how to use it to analyze companies.
What Is the Inventory Turnover Ratio?
The inventory turnover ratio is a straightforward method for determining how often a company turns over its inventory in a specified period of time. It's also known as "inventory turns." This formula provides insight into the efficiency of a company when converting its cash into sales and profits.
The inventory turnover ratio is an example of an efficiency ratio.
How Do You Calculate the Inventory Turnover Ratio?
The first step in calculating the inventory turnover ratio is to choose a timeframe to measure (eg, a quarter or a fiscal year). Then, find the average inventory for that period by averaging the ending and beginning costs of inventory for the timeframe in question. Once you have your timeframe and average inventory, simply divide the cost of goods sold (COGS) by the average inventory.
How the Inventory Turnover Ratio Works
You can save yourself a lot of trouble when assessing inventory turnover ratios by acquiring a company's balance sheet and income statement. COGS is usually listed on the income statement, and inventory balances will be found on the balance sheet. With these two documents, you just need to plug the numbers into the simple ratio formula, and you're done.
If you compare figures with other analysts, it's important to note that some analysts use total annual sales instead of the cost of goods sold. This is largely the same equation, but it includes a company's markup, so it can lead to a different result than equations that use the cost of goods sold. One isn't necessarily better than the other, but it is important to be consistent with your comparisons. Using annual sales to calculate the ratio for one company while using the cost of goods sold for another company won't give you any real sense of how the two companies compare.
Consider this real-world example. Coca-Cola's income statement from 2017 showed that the COGS was $13.256 million, and its average inventory value between 2016 and 2017 was $2.665 million. We can use these figures to calculate the ratio:
- Inventory turns = COGS / average inventory
- Inventory turns = $13.256 million / $2.665 million
- Inventory turns = 4.974
Now you know that Coca-Cola's inventory turns for that year was 4.974. You can compare this ratio to others in the soft drink and snack food industry to understand how well Coca-Cola is doing. If, for example, you found out that a competitor's inventory turns was 8.4, that would signal that the competitor is selling product more quickly than Coca-Cola.
There are many reasons why a company may have fewer inventory turns than another company—it doesn't necessarily mean that one company is worse than the other. It's important to read a company's financial statements and any accompanying disclosure notes to get a full picture. Although Coca-Cola's inventory turn rate was lower, you might find other metrics that show that it was still financially stronger than the other averages for its industry. Using historical data to compare current years to previous years could also provide helpful context.
Generally speaking, the more a company's assets are tied up in inventory, the more reliant that company is on faster turnover.
Inventory Turnover Days
You can take inventory analysis a step further by using the inventory turn rate to calculate the number of days it takes for a business to clear its inventory.
Continue with the Coca-Cola example, which provided an inventory turnover ratio of 4.974. Divide 365 by that inventory turns number, which should give you a result of 73.38. That means, on average, it took Coca-Cola 73.38 days to sell its inventory. This puts the company's efficiency in another context. Calculating the inventory turnover days doesn't necessarily provide any new information, but framing the same information in terms of days is helpful for some analysts.
Limitations of the Inventory Turnover Ratio
The time it takes a company to sell its inventory can vary greatly by industry, so if you don't know the average inventory turns for the industry in question, then the formula won't help your analysis all that much.
For example, retail stores and grocery chains typically have a much higher inventory turn rate because they sell lower-cost products that spoil quickly. As a result, these businesses require far greater managerial diligence. On the other hand, companies that manufacture heavy machinery, such as airplanes, will have a much lower turnover rate. It takes a long time to manufacture and sell an airplane, but once the sale closes it often brings in millions of dollars for the company.
- The inventory turnover ratio is an efficiency ratio that demonstrates how often a company sells through its inventory.
- You can calculate the inventory turnover ratio by dividing the cost of goods sold by the average inventory for a set timeframe.
- Dividing 365 by the inventory turnover ratio gives you the days it takes for a company to turn through its inventory.