Inventory Turnover Ratio Formula | Example
The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing the cost of goods sold with average inventory for a period. This measures how many times the average inventory is “turned” or sold during a period. In other words, it measures how many times a company sold its total average inventory dollar amount during the year. A company with $1,000 of average inventory and sales of $10,000 effectively sold its 10 times over.
This ratio is important because total turnover depends on two main components of performance. The first component is stock purchasing. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of inventory to improve its turnover. If the company can’t sell these greater amounts of inventory, it will incur storage costs and other holding costs.
The second component is the sales. Sales have to match inventory purchases otherwise the inventory will not turn effectively. That’s why the purchasing and sales departments must be in tune with each other.
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.
Average inventory is used instead of ending inventory because many companies’ merchandise fluctuates greatly throughout the year. For instance, a company might purchase a large quantity of merchandise on January 1 and sell that for the rest of the year. By December almost the entire inventory is sold and the ending balance does not accurately reflect the company’s actual inventory during the year. The average inventory is usually calculated by adding the beginning and ending inventory and dividing by two.
The cost of goods sold is reported on the income statement.
What Is A Good Inventory Turnover Ratio
Inventory turnover is the number of times a company sells and replaces its stock of goods during a period. Inventory turnover provides insight as to how the company manages costs and how effective their sales efforts have been.
- The higher the inventory turnover, the better since a high inventory turnover typically means a company is selling goods very quickly and that demand for their product exists.
- Low inventory turnover, on the other hand, would likely indicate weaker sales and declining demand for a company’s products.
- Inventory turnover provides insight as to whether a company is managing its stock properly. The company may have overestimated demand for its products and purchased too many goods as shown by low turnover. Conversely, if inventory turnover is very high, they might not be buying enough inventory and may be missing out on sales opportunities.
- Inventory turnover also shows whether a company’s sales and purchasing departments are in sync. Ideally, inventory should match sales. It can be quite costly for companies to hold onto inventory that isn’t selling, which is why inventory turnover can be an important indicator of sales effectiveness but also for managing operating costs. Alternatively, for a given amount of sales, using less inventory to do so will improve inventory turnover.
Inventory Turnover Ratio Calculator
The inventory turnover ratio is an important efficiency ratio. It dictates how fast a company replaces a current batch of inventories and transforms the inventories into sales.
How To Calculate Inventory Turnover Ratio
Cool Gang Inc. has the following information –
- Cost of Goods Sold – $600,000
- The beginning inventory – $110,000
- The 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.
Using the inventory ratio, we get –
- Inventory ratio = Cost of Goods Sold / Average Inventories
- Or, Inventory ratio= $600,000 / $120,000 = 5.
By comparing the inventory turnover ratios of similar companies in the same industry, we would be able to conclude whether the inventory ratio of Cool Gang Inc. is higher or lower.