The inventory turnover ratio is an efficiency ratio that shows you how effectively inventory is being managed by comparing cost of goods sold with average inventory for a period. This metric measures the amount of times average inventory is “turned” or sold during a period. In short, it measures how many times a company sold its total average inventory dollar amount during the year.
Quick Example: A company with $1,000 of average inventory and sales of $20,000 effectively sold it at 20 times over.
Why is your inventory turnover ratio important? Well, it’s a performance indicator that focuses on 2 core components.
- Purchasing Stock
Purchasing Stock: If large amounts of inventory are purchased during the year, the company must sell greater amounts of inventory to improve turnover. If the company can’t sell these greater amounts of inventory, turnover will be negative. This will lead to more storage costs and holding costs, both you want to avoid.
Sales: You want your sales to match inventory purchases. If you can’t match it, inventory will not turn effectively. This is exactly why your purchasing and sales departments have to work in conjunction.
Inventory Turnover Ratio Formula
The inventory turnover ratio is calculated by dividing the cost of goods sold for a period by the average inventory for that period.
You may be wondering why we use average inventory versus ending inventory.
We use average inventory versus ending inventory because most companies’ have merchandise that fluctuates throughout the year. For example, some companies may purchase large amounts of merchandise at the beginning of the year and they sell it throughout the year. By the time December rolls around, all of the purchased inventory is sold. In this scenario, the ending balance does not accurately reflect the company’s actual inventory during the year.
Finding your average inventory is an easy formula. Average inventory is usually calculated by adding the beginning and ending inventory and dividing it by 2.
The cost of goods sold is reported on the income statement.
An Important Retail Metric To Many
Now, since inventory turnover measures how efficiently a company can control its merchandise, it’s vital to have “high turn.” This would indicate that the company doesn’t overspend buying its inventory or wastes resources by storing non-salable inventory. It would also show that the company can effectively sell what inventory it buys.
There’s another big factor that this measurement shows, that is how liquid a company’s inventory is. If you’re looking for investors, they’ll want to see that retail metric.
Inventory is one of the biggest assets a retailer reports on a balance sheet. If this inventory can’t be sold, the inventory is worthless to that company. This measurement shows how easily a company can turn its inventory into cash, which is important for an investor thinking about investing in your business.
This metric is also important to creditors. Creditors are usually interested in this because inventory can be put up as collateral for loans. Banks want to know that this inventory will be easy to sell for cash.
Now, inventory turns vary from one industry to the next. For example, the apparel industry has one of the highest turn averages among all industries.
Inventory Turnover Ratio Example
Mel’s Furniture Company sells home furniture in California. During the current year, Mel reported cost of goods sold on its income statement of $1,000,000. Mel’s beginning inventory was $4,000,000 and its ending inventory was $5,000,000. Mel’s turnover is calculated like this:
.22 Times = $1,000,000 ÷ ($4,000,000 + $5,000,000) / 2
If this was a real example, this would show that Mel has bad inventory turnover. It means Mel sold less than 1/3 of his inventory for the year.
*Accelerated Analytics publishes resources like this to provide insights to different analytical metrics, data points and formulas. Please be aware, we’re not claiming that our POS reporting will offer this example or any other metric, data point or formula. To learn exactly what our reporting covers, please feel free to schedule a demo or give us a call. Thanks for understanding.