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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Inventory Turnover

What it is:

The inventory turnover ratio measures the rate at which a company purchases and resells products to customers. There are two formulas for inventory turnover:

 

        Sales               OR                  Cost of Goods Sold       
     Inventory                                   Average Inventory


The first formula is considered to be more common. The second formula accommodates the fact that sales are recorded at market value while inventory is recorded at cost, and its use of average inventory smoothes the effects of seasonal inventory changes. Because there are two formulas, it is important to be clear about which is being used when comparing inventory turnover ratios.

How it works (Example):

Let's assume Company XYZ reported the following information:

 

 



           


                                                                                  Last Year


           This Year


Revenue  


$1,000,000


$1,500,000


Cost of Goods Sold


$500,000


$600,000


 


 


 


Inventory       


$95,000


$100,000

Using the first formula and the information above, we can calculate that Company XYZ's inventory turnover ratio this year was:

$1,500,000 / $100,000 = 15 times

Using the second formula, Company XYZ's inventory turnover ratio this year was:

$600,000 / ($95,000 + $100,000) / 2 = 6.15 times

This means that Company XYZ effectively replenished its inventory 15 times (or 6.15 times) during the course of the year.

Why it Matters:

In general, low inventory turnover ratios indicate a company is carrying too much inventory, which could suggest poor inventory management or low sales. Excess inventory ties up a company's cash and makes the company vulnerable to drops in market prices. Conversely, high inventory turnover ratios may indicate a company is enjoying strong sales or practicing just-in-time inventory methods. High inventory turnover also means a company is replenishing cash quickly and has a lower risk of becoming stuck with obsolete inventory. However, higher is not always better, and exceptionally high inventory turnover may indicate a company is running out of items frequently or making ineffective purchases and therefore losing sales to competitors.

It is important to understand that the timing of inventory purchases, particularly those made in preparation for special promotions or new-product introductions, can suddenly and somewhat artificially change the ratio.

Different choices in inventory accounting methods can also affect inventory turnover ratios. In periods of rising prices, companies using the last-in-first-out (LIFO) inventory method show higher costs of goods sold and lower inventories than companies using the first-in-first-out (FIFO) method. Thus, LIFO companies generally report higher inventory turnover ratios than FIFO companies, even when the companies are very similar. Additionally, companies using LIFO also tend to carry more inventory than FIFO companies; the LIFO method increases cost of goods sold, which reduces profits and in turn lowers tax liabilities.

Inventory turnover ratios vary by company as well as by industry. Low-margin industries tend to have higher inventory turnover ratios than high-margin industries because low-margin industries must offset lower per-unit profits with higher unit-sales volume.

For all of these reasons, comparison of inventory turnover ratios is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.