Inventory Turnover Ratio

How to Calculate Inventory Turnover Ratio (Step-by-Step)

The inventory turnover ratio portrays the efficiency at which the inventory of a company is turned into finished goods and sold to customers. In other words, the ratio measures how well a company can convert its inventory purchases into revenue.

The ratio is calculated by dividing the cost of goods sold (COGS) by the average inventory balance for the matching period. Thus, the metric determines how long it takes for a company to sell its entire inventory (and need to place more orders).

The steps for calculating the inventory turnover ratio are the following:

• Step 1 → Calculate the average inventory by adding the prior period inventory balance and ending inventory and then dividing by two.
• Step 2 → Divide the numerator, the cost of goods sold (COGS) in the corresponding period, by the average inventory as calculated above.

Inventory Turnover Ratio Formula

The formula used to calculate a company’s inventory turnover ratio is as follows.

While COGS is pulled from the income statement, the inventory balance comes from the balance sheet.

In effect, a mismatch is created between the numerator and denominator in terms of the time period covered.

• Income Statement → The financial performance, such as revenue, costs, and profitability, of a company across two periods.
• Balance Sheet → A “snapshot” at a specific point in time of a company’s assets, liabilities and equity.

What is a Good Inventory Turnover Ratio? (High or Low)

Since the inventory turnover ratio represents the number of times that a company clears out its entire inventory balance across a defined period, higher turnover ratios are preferred.

• High Inventory Turnover Ratio → The company likely experiences strong demand in the market for its products, as confirmed by the high turnover and the frequent need for inventory replenishment.
• Low Inventory Turnover Ratio → There might be poor demand in the market and excess inventory accumulating (i.e. overstocking). The company’s inventory, if left unsold, might eventually need to be written down to reflect the true (lower) value on the balance sheet.

Inventory Management: How to Interpret Inventory Turnover Period

Comparing a company’s ratio to its industry peer group can provide insights into how effective management is at inventory management.

For companies with low turnover ratios, the duration between when the inventory is purchased, produced/manufactured into a finished good, and then sold is more prolonged (i.e. requires more time). That said, low turnover ratios suggest lackluster demand from customers and the build-up of excess inventory.

For example, retailers are typically known for exhibiting high turnover ratios – in particular, “fast-fashion” retailers like Zara are highly regarded for their ability to research trends and clear out their inventory quickly.

However, if a company’s inventory has an abnormally high turnover, it could also be a sign that management is ordering inadequate inventory as opposed to managing inventory well.

In such cases, the amount of pent-up demand (i.e. back orders, delayed deliveries, and speed) must be evaluated to understand the reality of the circumstances, as well as to see if there is an adverse impact on revenue.

Rather than being a positive sign, high turnover could mean that the company is missing potential sales due to insufficient inventory.

Some examples of practical diligence questions to ask (or answer) from assessing a company’s inventory management are the following:

• Q. Is the company pricing its products at a competitive rate where there is sufficient customer demand?
• Q. Does the revenue generated from the sale of proceeds offset the expenses to be profitable?
• Q. Have recent purchases referenced historical customer demand patterns?
• Q. Which specific products have been selling out quickly and causing lost revenue (and vice versa)?
• Q. Are there any specific products that have lost a substantial amount of consumer demand as of late?