Inventory turnover ratio

Published: Oct 2008

Inventory turnover is a ratio which indicates how frequently a business sells and replaces its inventory during the course of a year. The words inventory and stock are used interchangeably in this description and have the same meaning.

Tracking the turnover of a business in this way can be critical to successful financial planning, particularly if the business has significant assets tied up in inventory. For example, having high levels of inventory means that funds will be required to pay for storage of the stock. Money is also needed to purchase the inventory and to ensure that stock is available when it is required. This ratio can therefore help companies to monitor the level of stock that has to be maintained in order to meet the demands of their clients as efficiently as possible.

Simple inventory turnover can be calculated as follows:

$$Inventory \: turnover \:\: = \:\: \frac{sales}{inventory}$$

For example, we could say that Company ABC has sales of €20m and inventory of €25m for 2007. The company’s inventory turnover is therefore 0.8. This would be considered to be a fairly low figure and in practice it means that it would take the company more than a year to deplete its current inventory.

The inventory turnover ratio is most frequently used by investors as a simple efficiency ratio. As sales are recorded at market value however, this method can be substituted with the inventory to cost of goods sold (COGS) ratio, which can provide a more meaningful result as inventory is usually recorded at cost. Average inventory for the period can also improve the calculation if this helps to minimise the effect of seasonality:

$$Inventory \: turnover \: = \: \frac{cost \: of \: goods \: sold}{average \: inventory*}$$
$$*Where\: average \: inventory \:\: = \:\: \frac{beginning \: inventory \: + \: ending\: inventory}{2}$$

Take for example Company XYZ where the cost of goods sold during 2007 was €26m, the beginning inventory was €6m and the ending inventory was €7m. Using the above formula, the average inventory is €6.5m and therefore the inventory turnover is 4.

Interpretation of results

Ratios should be compared with industry averages as inventory is sector specific, with inventory turnover being higher when goods are perishable, for example. Trade association surveys are a useful source for locating a suitable industry ratio to use as a benchmark. Generally speaking however, a lower turnover ratio implies poor sales and/or poor inventory management together with overstocking, old stock becoming obsolete and possibly a poor product line or disappointing marketing campaign.

Conversely, a higher turnover rate could suggest strong sales. On the other hand, it could also be an indication of ineffective buying – ie the turnover is high and the inventory is small, but there may be insufficient stock to meet demand at peak times.

The turnover ratio provides a two dimensional snapshot of a business which is undoubtedly useful to investors comparing companies and those in charge of inventory management. As with most ratios though, it is a purely mathematical measure which ignores the three dimensional practical and/or tactical sides of inventory. That is to say that a company may be strategically keeping its inventory high – for example, it may be stocking up on raw materials if a price rise is anticipated or if a shortage has been forecast.

It should be remembered that inventory yields zero return until sold and also expose the company to risk – both physically, for example if the stock is destroyed in a warehouse fire,sales and also economically, should prices fall.