Inventory turnover is a ratio that shows how many times a company’s inventory is sold and replaced over a given period. It is a key measure of inventory efficiency, the speed at which a company can sell its goods, and is often used by businesses to evaluate their inventory management.
The formula to calculate inventory turnover is:
Inventory Turnover = Cost of Goods Sold / Average Inventory
- Cost of Goods Sold (COGS) is the total cost of all goods sold over a specific time period.
- Average Inventory is the mean value of the inventory during that time period, calculated by adding the inventory at the start of the period to the inventory at the end of the period, and dividing by 2.
A higher inventory turnover ratio indicates that a company is selling its products quickly, which is generally positive as it suggests strong sales, less money tied up in inventory, and a lower risk of inventory becoming obsolete. However, if the ratio is too high, it may mean that the company is not keeping enough stock on hand to meet demand, leading to lost sales.
On the other hand, a lower inventory turnover ratio could indicate weak sales and excess inventory, suggesting potential cash flow issues and a higher risk of inventory obsolescence. But if the ratio is too low, it could also mean that the company is holding too much inventory, which could lead to higher storage costs and potential wastage.
Different industries have different average inventory turnover rates, so this ratio is often compared against industry benchmarks or against a company’s historical performance.
Example of Inventory Turnover
Let’s consider a fictional company, XYZ Retailers.
Suppose that over the course of the year, XYZ Retailers sold goods that cost a total of $1,200,000 to acquire or produce (this is their cost of goods sold, or COGS). Their inventory at the beginning of the year was worth $150,000 and at the end of the year was worth $250,000.
Average Inventory = ($150,000 + $250,000) / 2 = $200,000
Next, use the inventory turnover formula:
Inventory Turnover = COGS / Average Inventory
So, for XYZ Retailers:
Inventory Turnover = $1,200,000 / $200,000 = 6
An inventory turnover of 6 means that XYZ Retailers sold and replaced its inventory six times over the course of the year. This provides a baseline for the company to compare with industry standards or its own historical performance. It might lead to further questions, such as whether the company could improve its sales performance or whether it’s managing its inventory levels efficiently.