What Is An Inventory Turnover Ratio?
The inventory turnover ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. A higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings.
The inventory turnover ratio varies from industry to industry. For example, a clothing retailer company’s turnover can be 5 to 8, whereas an automotive parts company may have an inventory turnover of 45 to 50.
Table of contents
- The inventory turnover ratio determines how quickly the company can replace and transform a batch of inventories into sales.
- A higher ratio means the company’s product is in high demand and sells rapidly, which may result in lower inventory management costs and more earnings. Moreover, it varies from industry to industry.
- There are fewer chances of obsolescence when the inventory turnover ratio is high.
- When the company’scompany’s inventory turnover is low, the products often need to be sold in the market. Consequently, the company inventory could be faster, resulting in higher costs and fewer profits.
Inventory Turnover Ratio Explained
The inventory turnover ratio helps assess how efficiently a company uses its inventory against the Cost of Goods Sold (COGS). Having a clear picture of how the inventory is being used helps businesses make more informed decisions, be it related to pricing, marketing, production, etc.
The ratio indicates the efficient handling and utilization of assets, which shows how effective a company is in managing its resources and functioning smoothly. It tells stakeholders, both internal and external, how many times a business or a company has sold its inventory or replenished the same over a period.
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Inventory Turnover Ratio Explained in Video
The inventory turnover ratio formula is:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Let us take a simple example to illustrate how to calculate the inventory turnover ratio:
Example 1 – Calculation Example
Cool Gang Inc. has the following information:–
- Cost of goods sold – $600,000
- The beginning inventory – $110,000
- The ending inventory – $130,000
Find out the inventory ratios.
The average inventory of Cool Gang Inc. would be = (The beginning inventory + the ending inventory)/2 = ($110,000 + $130,000)/2 = $240,000/2 = $120,000.
We can get the inventory ratio as –
- Inventory ratio = Cost of Goods Sold / Average Inventories
- Or, Inventory ratio= $600,000 / $120,000 = 5.
By comparing the inventory turnover ratios of similar companies in the same industry, we would conclude whether the inventory ratio of Cool Gang Inc. is higher or lower.
Example 2 – Colgate’s Real-Life Scenario
Below is the snapshot of inventory turnover calculations. You may download this excel sheet from Ratio Analysis Ratio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.. Colgate’s inventory consists of three types of Inventory Types Of InventoryDirect material inventory, work in progress inventory, and finished goods inventory are the three types of inventories. The raw material is direct material inventory, work in progress inventory is partially completed inventory, and finished goods inventory is stock that has completed all stages of production. – raw material and supplies, work in progress, and finished goods.
Historically, Colgate’s inventory turnover has been in the range of 5x-6x. However, if we observe closely, Colgate’s inventory turnover was slightly lower from 2013 to 2015. It indicates Colgate is taking a bit longer to process its inventory into finished goodsInventory Into Finished GoodsFinished goods inventory refers to the final products acquired from the manufacturing process or through merchandise. It is the end product of the company, which is ready to be sold in the market. .
When the inventory turnover ratio is high, it depicts that the company has been managing its inventory quite well, with lesser holding costsHolding CostsHolding cost refers to the cost that an entity incurs for handling and storing its unsold inventory during an accounting period. It is calculated as the sum total of storage cost, finance cost, insurance, and taxes as well as obsolescence and shrinkage cost. and fewer chances of obsolescence. Hence, a high figure will mean a good inventory turnover ratio.
On the other hand, when the inventory turnover ratio is low, it signifies that a company’s inventory turnover is very low, and its products are often not sold in the market. As a result, the company’s inventory becomes a slow-moving inventory, which leads to higher inventory costs and fewer profits.
One can understand whether the ratio is high or low by looking at the inventory ratio of similar companies in the same industry. They can notice the base if they take an average inventory turnover ratio. Based on this, they can measure whether the inventory ratio of a company is higher or lower.
How To Improve?
To improve its ratio, the company can adopt the following strategies: –
- 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.
Inventory turnover is a great indicator of how a company handles its inventory. If an investor wants to check how well a company is managing its inventory, she would look at how higher or lower the company’s inventory turnover ratio is.
Frequently Asked Questions (FAQs)
One method is to divide the cost of products by the average inventory for the same period to determine the inventory turnover ratio.
For retail, a good inventory turnover ratio is between 2 and 4. However, the criteria can differ amongst industries. Therefore one must examine them. Low inventory turnover may indicate problems with the sales plan or low product demand.
A low inventory turnover ratio indicates weak sales or excessive inventory. It is also known as overstocking. Moreover, it also needs to show a problem with a retail chain’s merchandising strategy or inadequate marketing. On the other hand, a high inventory turnover ratio indicates strong sales.
For most industries, a good inventory turnover ratio is between 5 and 10, indicating that you sell and restock your inventory every 1-2 months.
This article is a guide to what is Inventory Turnover Ratio. We explain its formula with calculation examples, interpretation, how to improve, and importance. You may also have a look at these articles below to learn more about financial analysis: –