What is the Inventory Turnover Ratio?
Inventory Turnover Ratio helps in measuring the efficiency of the company with respect to managing its inventory stock to generate sales and is calculated by dividing the total cost of goods sold with the average inventory during a period of time.
Formula to Calculate Inventory Turnover Ratio
It is an important efficiency ratio that dictates how fast a company replaces a current batch of inventories and transforms the inventories into sales.
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.
Colgate’s Inventory Turnover Calculation
In this Inventory Turnover example, we take a real-life example of Colgate. Below is the snapshot of Inventory Turnover Ratio Calculations. You may download this excel sheet from Ratio Analysis. Colgate’s inventory consists of three types of Inventory – 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 ratio 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 goods.
As you can see, there are two significant components of this ratio.
The first component is the costs of goods sold. If we look into the income statement of a company, we will find the cost of goods sold quite easily. All we need to do is to look at the fourth item on the income statement.
Here’s a snapshot –
Income Statement of TCL Co. at the end of the year 2017
|Particulars||Amount (in $)|
|(-) Sales Returns||($50,000)|
|(-) Cost of Goods Sold||($210,000)|
The second component of the formula is average inventories.
To find out the average inventories, we need to use the simple average method.
We need to find out the beginning inventories and the ending inventories for the period, and then all we need to do is to divide the sum by two.
- For example, if the beginning inventory of a firm is $40,000 and the ending inventory is $50,000, then to find out the average inventory, we need to add these two and divide the sum by two.
- Here’s the calculation = ($40,000 + $50,000)/2 = $45,000.
Interpretation of Inventory Turnover Ratio
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.
For example, let’s say that the inventory ratio of a company is very high. It means that the company has been managing its inventory quite well, and there are lesser holding costs and fewer chances of obsolescence.
On the other hand, if the inventory ratio of a company is lower, the company is not being able to manage the inventory quite well. And there’s also a risk of obsolescence.
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.
Inventory Turnover Ratio Calculator
|Inventory Turnover Ratio Formula =||
Inventory Turnover Ratio Formula in Excel (with excel template)
Let us now do the same example above in Excel.
This is very simple. First, you need to find out the Average Inventories, and then you need to provide the two inputs of Cost of Goods Sold and Average Inventories. You can easily calculate the Inventory ratio in the template provided.
Inventory Turnover Ratio Formula Video
This article has been a guide to the Inventory Turnover Ratio and its meaning. Here we discuss the formula to calculate the Inventory Turnover ratio along with examples & excel templates. You may also have a look at these articles below to learn more about Financial Analysis