What is Inventory Turnover?
Inventory turnover is a comparison of average inventory held by an organization with the cost of goods sold. In simple words, a number of times goods sold or consumed by an organization, and the ratio is also used to calculate the estimated time period required to sale the inventory held by the organization.
Inventory Turnover Formula
It can be calculated as follows:
Explanation
This ratio is used by an organization to calculate the number of times it is selling goods and replace its stock during a given period of time. This ratio also helps in showing how effectively a company manages its inventory cost and how effectively its sales efforts are converted into figures. For the calculation of inventory turnover, we need to understand the following items:
Cost of Goods Sold
We use the cost of goods sold from the income statement since the cost of goods sold includes purchase cost as well as the cost incurred by the organization to manage such inventory, such as storage cost, handling cost, wages, and labor charges, etc.
Average Inventory Held
We use average inventory during the period is used instead of closing inventory since there might be situations where the company had an opening stock of inventory and purchased very less quantity of goods and the year-end it had sold most of the goods and if we use closing inventory, the ratio will not be based on inventory held by the organization during the period, which will not display the actual picture of time period taken by the organization to generate such sales.
Examples of Inventory Turnover Calculation (with Excel Template)
Let’s see some simple to advanced practical examples to understand it better.
Example #1
Company STYLISH Ltd. is operating in the clothing products and income statement of last year of the company shows the following figures. You need to calculate the inventory turnover ratio.
- Opening Inventory: 24,560
- Closing Inventory: 1540
- Cost of Goods Sold: $452,700
Solution
Use below given data for the calculation.
Calculation of Average Inventory
- =(24560+1540)/2
- Average Inventory = 13050
- =452700/13050
Inventory Turnover will be –
Example #2
Taking the concept of inventory formula ahead, we will learn to calculate inventory turnover ratio as well as the inventory holding period. Suppose Company Furniture and fixtures Pvt. Ltd. manufactures chairs and tables. Its income statement shows that it had an opening inventory of 86900, and during the period, it manufactures chair and table costing 3495000, and at the end of the period, it had 635000 as stock in hand of inventory. We need to calculate the inventory turnover ratio as per as inventory holding period.
Solution
Use below given data for the calculation.
Calculation of Cost of Goods Sold
- =86900+3495000-635000
- Cost of Goods Sold = 2946900
Calculation of Average Inventory
- =(86900+635000)/2
- Average Inventory = 360950
The calculation can be done as follows-
- = 2946900/360950
Inventory Turnover will be –
Inventory Holding Period
- = 365/ Inventory turnover Ratio
- = 365/8.16
- = 44.71 days
This means that the company roughly takes one and a half months to replace it is stock and sell its complete stock in hand.
Example #3
Taking another example to understand the benefit of using the inventory turnover ratio formula in practical life, Suppose Company Delta has an opening stock of $ 326,500 and purchased goods amounting to $ 5,284,600, and it paid direct expenses relating to goods handling are 65,300. At the end of the accounting period, it had $ 765,300 as a closing inventory. We need to calculate the inventory turnover ratio formula, as well as the inventory holding period.
Solution
Use below given data for the calculation.
Calculation of Cost of Goods Sold
- =326500+5284600+65300+765300
- Cost of Goods Sold = 4911100
Calculation of Average Inventory
- =(326500+765300)/2
- Average Inventory = 545900
The calculation can be done as follows-
- =4911100/545900
Inventory Turnover will be –
Inventory Holding Period
- Inventory Holding Period = 40.57
Calculator
You can use these inventory turnover formula calculator
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Relevance and Use
- It varies from industry to industry. For example, a clothing retailer company may have an inventory turnover of 5 to 8, whereas an automotive parts company may have a turnover of 45 to 50. So this shows that it is a very important tool in making strategies and achieving company objectives.
- Inventory turnover depends on purchase and sale. If a company purchase high-value items, then it has to sell to be matched with purchase; otherwise, the company has to bear storage and handling the cost of high-value inventory.
- In decision making, inventory turnover also plays a very important role, as explained below:
Higher Ratio
If the inventory turnover ratio is high, it means that the company’s product has very good demand in the market, and products are sold very quickly, which leads to less inventory maintenance costs and higher profits.
Lower Ratio
If the inventory ratio of a company is very low, it indicates that the company’s products are not often sold in the market, and inventory of the company becomes a slow-moving inventory, which leads to higher inventory costs and fewer profits.
If a company is suffering from a low inventory turnover ratio, it can adopt the following strategies to improve its inventory turnover ratio:
- Review strategies relating to the pricing of products.
- Try to improve sales by using marketing techniques.
- Analyze the fast-moving inventory and slow-moving inventory
- Improve bargain power and review the purchase price regularly
- Understand the customers’ needs and try to get an order from customers well in advance.
Recommended Articles
This article has been a guide Inventory Turnover Formula. Here we discuss the formula for calculation of inventory turnover along with practical examples and a downloadable excel template. You can learn more about financial analysis from the following articles –
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