What is the Inventory Turnover Ratio?
Inventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. 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 may have a turnover of 5 to 8, whereas an automotive parts company may have an inventory turnover of 45 to 50.
Inventory Turnover Ratio Formula
Inventory Turnover Ratio Formula = Cost of Goods Sold / Average Inventory
Let’s take a simple example to illustrate this.
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.
Using the inventory ratio, we get –
- 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 be able to conclude whether the inventory ratio of Cool Gang Inc. is higher or lower.
In this example, we take a real-life example of Colgate. Below is the snapshot of Inventory Turnover Calculations. You may download this excel sheet from Ratio AnalysisRatio 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 InventoryTypes 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. If we observe closely, Colgate’s Inventory turnover was a bit lower in the period of 2013-2015. This indicates that 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. .
Inventory turnover is a great indicator of how a company is handling 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 inventory turnover ratio of the company is.
When Inventory Turnover Ratio is High – It means that the company has been managing its inventory quite well, and there are 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.
When Inventory Turnover Ratio is Low – If the inventory turnover 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.
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.
But how would you understand whether the ratio is higher or lower?
You would understand it by looking at the inventory ratio of similar companies in the same industry. If you take an average of the inventory turnover ratio, you would understand the base. On this base, you can measure whether the inventory ratio of a company is higher or lower.
This article has been a guide to the Inventory Turnover Ratio and its meaning. Here we discuss the formula to calculate the Inventory Turnover along with examples & excel templates. You may also have a look at these articles below to learn more about Financial Analysis