What is the Inventory Turnover Ratio?

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.

Inventory Turnover Ratio Formula

Inventory Turnover Ratio Formula = Cost of Goods Sold / Average Inventory

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Inventory Turnover Ratio (wallstreetmojo.com)

Example

Let us take a simple example to illustrate this.

  • Cost of goods sold – $600,000The beginning inventory – $110,000The 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 InventoriesOr, Inventory ratio= $600,000 / $120,000 = 5.

Colgate’s Example

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 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.read more. 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.read more – 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. read more.

Interpretation

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.

When Inventory Turnover Ratio is High – 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.read more and fewer chances of obsolescence.

When Inventory Turnover Ratio is Low – If a company’s inventory turnover is very low, 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.

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. You will understand the base if you take an average inventory turnover ratio. On this basis, you can measure whether the inventory ratio of a company is higher or lower.

Video

This article is a guide to the Inventory Turnover Ratio. Here we discuss the the inventory turnover ratio formula, examples, and Excel templates. You may also have a look at these articles below to learn more about financial analysis: –

  • Profit vs. TurnoverInventory RatioExample of WIP InventoryRatio in Excel