The inventory turnover ratio (ITR) is a formula that helps you figure out how long it takes for a business to sell through its entire inventory. A higher ITR usually means that a business has strong sales compared to a company with a lower ITR.
Learn how to find ITR and how to use it to analyze companies.
Definition and Examples of Inventory Turnover Ratio
The inventory turnover ratio is a simple method to find out how often a company turns over its inventory during a specific length 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.
For example, a company like Coca-Cola could use the inventory turnover ratio to find out how quickly it's selling its products compared to other companies in the same industry.
- Acronym: ITR
How the Inventory Turnover Ratio Works
You can save yourself a lot of trouble when finding ITRs by looking at a company's balance sheet and income statement. COGS is often listed on the income statement; inventory balances will be found on the balance sheet. With these two documents, you just need to plug the numbers into the formula. Then, you're done.
The ITR is just one type of efficiency ratio, but there are many others.
If you compare figures, keep in mind 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. That means it can lead to a different result than equations that use the cost of goods sold.
One isn't better than the other, but be sure you are consistent with your comparisons. You don't want to use annual sales to find the ratio for one company while using the cost of goods sold for another. It wouldn't give you any real sense of how the two compare.
How Do You Calculate the Inventory Turnover Ratio?
The first step for finding the ITR is to choose a timeframe to measure (e.g., a quarter or a fiscal year). Then, find the average inventory for that period. You can do this by averaging the ending and beginning costs of inventory for the time in question. Once you have your timeframe and average inventory, simply divide the cost of goods sold (COGS) by the average inventory.
Inventory Turnover Ratio Calculation Example
Consider this real-world example. Coca-Cola's income statement from 2017 showed that the COGS was $13.256 million. Its average inventory value between 2016 and 2017 was $2.665 million. We can use these figures to find 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 to others in the soft drink and snack food industry to figure out how well Coca-Cola is doing. Let's say, for instance, that you found out that a competitor's inventory turns was 8.4. That would signal that the competitor is selling products more quickly than Coca-Cola.
There are many reasons why a company may have a lower ITR than another company. It doesn't always mean that one company is worse than the other. Be sure you read a company's financial statements and any notes to get a full picture.
Although Coca-Cola's ITR was lower, you might find other metrics that show that it was still stronger than the other averages for its industry. Using historical data to compare current years to past years could also provide helpful context.
In many cases, the more a company's assets are tied up in inventory, the more they rely on faster turnover.
Inventory Turnover Days
You can take this a step further by using the inventory turn rate to find the number of days it takes for a business to clear its inventory.
Let's keep going with the Coca-Cola example. In that case, its ITR was 4.974. Next, we divide 365 by that number; this should give a result of 73.38. That means, on average, it took Coca-Cola 73.38 days to sell its inventory.
This puts their efficiency in another context. Finding the inventory turnover days doesn't provide any new information. But framing it in terms of days is helpful for some.
Limitations of the Inventory Turnover Ratio
The time it takes a company to sell through its supply can vary greatly by industry. If you don't know the average inventory turns for the industry in question, then the formula won't help you very much.
For instance, retail stores and grocery chains typically have a much higher ITR. That's 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 make 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 (ITR) demonstrates how often a company sells through its inventory.
- You can find the ITR by dividing the cost of goods sold by the average inventory for a set timeframe.
- Dividing 365 by the ITR gives you the days it takes for a company to turn through its inventory.