The inventory turnover ratio is an efficiency ratio that measures the number of times a company sells and replaces stock during a set period, generally one year. While you shouldn’t base decisions solely on it, a high inventory turnover is generally positive and means you have good inventory control, while a low ratio typically indicates the opposite. There are exceptions to this rule that I will also cover in this article.
The inventory turnover ratio formula divides your COGS by your average inventory.
| Inventory Turnover Ratio | = | COGS |
| Average Inventory |
Key Takeaways for the Inventory Turnover Ratio
- The ratio can affect your ability to receive approval for a loan. Inventory is often the most valuable asset on your balance sheet. As a result, banks tend to accept it as collateral for a small business loan, provided you can sell the inventory quickly.
- The ideal ratio varies by industry. A high turnover ratio is ideal for companies that sell low-cost, perishable items like a grocery store. However, a low turnover ratio is common for businesses that sell luxury items, such as cars and homes.
- The ratio measures sales and inventory efficiency. The sales and purchasing departments need to work together to manage inventory. Sales reps know what products are in demand, and purchasing is responsible for replenishing stock. If these two are not in sync, you will have difficulty meeting customer demand without investing too much cash in unnecessary inventory.
How to Calculate the Inventory Turnover Ratio
Step 1: Calculate the Cost of Goods Sold
The cost of goods sold (COGS) includes all materials and labor used to create your products or services. If you use one of the best small business accounting software solutions, you can run a profit and loss report to get your COGS or calculate your COGS by adding your beginning inventory and purchases and then subtracting your ending inventory.
COGS Example: ABC Company
Let’s assume ABC Company has a beginning inventory of $10,000, makes purchases throughout the year that total $50,000, and has an ending inventory of $20,000. The COGS for ABC Company is calculated as follows:
($10,000 + $50,000) − $20,000 = $40,000
Step 2: Calculate Average Inventory
The formula to calculate average inventory adds your beginning and ending inventory and then divides that number by two.
| Average Inventory | = | (Beginning Inventory + Ending Inventory) |
| 2 |
Note that because inventory fluctuates for many companies throughout the year, using the average inventory for the period—rather than editing inventory—to calculate your ratio tends to be more accurate. However, if your inventory doesn’t fluctuate much, use the ending inventory instead.
Average Inventory Example: ABC Company
Let’s assume the balance sheet for ABC Company as of January 1 shows a beginning inventory of $10,000 and an ending inventory of $20,000 as of December 31. The average inventory for ABC Company is calculated as follows:
($10,000 + $20,000) ÷ 2 = $15,000
Step 3: Calculate the Inventory Turnover Ratio
The inventory turnover ratio is calculated by dividing COGS by the average inventory.
| Inventory Turnover Ratio | = | COGS |
| Average Inventory |
Inventory Turnover Ratio Example: ABC Company
As shown in the example above for ABC Company, you would calculate the inventory turnover ratio by dividing $40,000 (COGS amount) by $15,000 (average inventory) for a total of 2.67. Essentially, ABC Company turns over its inventory almost three times in a given period.
$40,000 ÷ $15,000 = 2.67
How to Interpret the Inventory Turnover Ratio
Like other financial ratios, the inventory turnover ratio is only one piece of information about a company’s ability to manage its inventory. I’ve found that comparing your industry to your turnover ratio can help you determine whether it’s good or needs improvement.
- Generally, but not always, a high inventory turnover ratio indicates that a business manages its stock very well. While it can reflect strong sales, it could also signal insufficient inventory on hand, which could lead to lost business. The speed at which a company can sell inventory is an important measure of business performance.
- A low inventory turnover ratio could mean a business does a poor job of managing its stock. It can also imply weak sales, possibly excess inventory, or even an issue with obsolete goods being offered for sale.
For example, grocery stores typically have a higher inventory turnover ratio because they sell lower-cost products that can spoil quickly. In contrast, car manufacturers have a low inventory turnover rate because they sell high-value items that take time to produce. The key is to find the standard ratio for your industry to compare your ratio to similar businesses.
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Frequently Asked Questions (FAQs)
An inventory turnover ratio measures how often a company sells and replaces its inventory during a specific period. Essentially, it shows how quickly a company sells its goods and how efficiently it manages stock.
The ideal ratio varies by industry. In most cases, high inventory ratios are ideal because they indicate that your company does a good job of turning inventory into sales. However, sellers of high-end goods may have lower turnover ratios because of the high cost and long manufacturing time.
The inventory turnover ratio measures how often the inventory is sold and replaced over a given period. Days sales of inventory (DSI)―also known as days inventory―is the number of days it takes to turn inventory into sales.
The formula for DSI is: Days Sales of Inventory = (Average Inventory ÷ COGS) × 365
An inventory turnover ratio of 5 means a company sells and replaces its entire inventory five times during a given period, usually a year. That signifies good efficiency. An inventory turnover ratio from 5 to 10 for most industries is considered healthy. It suggests the company is managing its inventory efficiently, balancing having enough stock to meet demand without tying up excessive capital in unsold goods.
While a high ratio generally seems positive, it can sometimes indicate stockouts because the company may not have enough inventory to meet demand, potentially leading to lost sales. It might also be ordering too frequently, incurring higher ordering costs.
Bottom Line
The inventory turnover ratio shows how often a company has sold and replaced inventory during a given period. Calculating this ratio can help businesses make better decisions on manufacturing, pricing, marketing, and purchasing new inventory. Depending on your industry, a slow turnover may imply weak sales or possibly excess inventory, whereas a fast turnover ratio can indicate either strong sales or insufficient inventory.
