The inventory turnover ratio is an efficiency ratio that measures how quickly inventory is turned into sales. A high inventory turnover is generally positive and means a company has good inventory control while a low ratio typically indicates the opposite. There are exceptions to this rule that we also cover in this article.
If you use accounting software like QuickBooks, calculating your inventory turnover ratio is a breeze. You can run a profit and loss report and a couple of balance sheet reports to get the numbers you need. Plus, QuickBooks allows you to keep track of all income and expenses. Pricing starts at only $20 per month, plus you get the first 30 days free.
What the Inventory Turnover Ratio Is
The inventory turnover ratio is 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 this information, high turnover is usually ideal because it indicates that a company is doing a good job of managing its stock.
The inventory turnover ratio formula is:
Cost of goods sold / Average inventory = Inventory turnover ratio
How to Calculate the Inventory Turnover Ratio
The inventory turnover ratio is calculated by taking the cost of goods sold and dividing it by the average inventory over a given time. You get the cost of goods sold by adding up the direct cost of materials and labor used to produce a product. You can locate this figure directly below revenue on a profit and loss statement.
The second component is the average inventory. Average inventory is computed by adding the inventory at the beginning of the period and the inventory at the end of the period and then dividing the result by two. Both your beginning and ending inventory can be found on your balance sheet report. The beginning inventory is the recorded cost of your inventory as of January 1 (or the beginning of your fiscal year), and the ending inventory figure is the cost of your inventory as of December 31 (or the end of your fiscal year).
Because inventory fluctuates for many companies throughout the year, using the average inventory for the period to calculate your ration tends to be more accurate than using the ending inventory. However, if your inventory does not fluctuate a whole lot, using the ending inventory instead of the average inventory could work.
1. Calculate the Cost of Goods Sold
As previously mentioned, the cost of goods sold includes all materials and labor used to create the products or services you sell. If you use accounting software, you can run a profit and loss report to get your cost of goods sold figure. To calculate the cost of goods sold manually, you take beginning inventory plus purchases during the period and subtract ending inventory.
The formula to calculate the cost of goods sold is:
(Beginning inventory + purchases) – Ending inventory = Cost of goods sold
Cost of Goods Sold Example: ABC Company
Let’s assume ABC Company has a beginning inventory of $10,000 and makes purchases throughout the year that total $50,000. Its ending inventory is $20,000. The cost of goods sold for ABC Company is calculated as follows:
Beginning inventory + Purchases – Ending inventory = Cost of goods sold
$10,000 + $50,000 – $20,000 = $40,000
2. Calculate Average Inventory
To calculate the average inventory, you need to take the inventory at the beginning of the period (e.g., January 1) and add it to the inventory balance at the end of the period. Take that result and divide it by two to get the average inventory for the year. You can run a balance sheet report to get your inventory numbers.
The formula to calculate average inventory is:
(Beginning inventory + Ending inventory) / 2 = Average inventory
Average Inventory Example: ABC Company
Let’s assume the balance sheet for ABC Company as of January 1 shows a beginning inventory of $20,000 and an ending inventory of $30,000 as of December 31. The average inventory for ABC Company is calculated as follows:
(Beginning Inventory + Ending Inventory) / 2 = Average Inventory
($20,000 + $20,000) / 2 = $20,000
3. Calculate Inventory Turnover Ratio
Now that we have calculated the cost of goods sold and the average inventory for ABC Company, we can calculate the inventory turnover ratio. To calculate the ratio, we will divide the cost of goods sold by the average inventory.
The inventory turnover ratio is calculated as follows:
Cost of goods sold / Average inventory = Inventory turnover ratio
$40,000 / $20,000 = 2
How to Interpret the Inventory Turnover Ratio
Generally, a high inventory turnover ratio indicates that a business manages its stock very well. A low ratio could mean a business does a poor job of managing its stock. Your industry can help you to determine if your turnover ratio is good or needs improvement.
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 turn rate because they sell high-value items that take time to produce. The key is to find out what the standard ratio is for your industry so that you can compare your ratio to similar businesses.
You should also note that an extremely higher rate of inventory turnover could mean you’re missing out on potential sales because you can’t keep enough inventory in stock to meet demand. On the flip side, a very low inventory turnover ratio might indicate you purchase more inventory than you can sell, which could result in obsolete inventory and additional costs for warehouse storage.
Inventory Turnover Ratio Examples
In this section, we will demonstrate how to calculate inventory turnover by walking through a few examples. Also, we have included a brief explanation of what the inventory ratio means for the business.
Inventory Turnover Ratio: XYZ Company
Let’s assume XYZ Company has a cost of goods sold of $25,000, beginning inventory of $100,000, and ending inventory of $60,000.
The inventory turnover ratio for XYZ Company is calculated as follows:
Cost of goods sold / Average inventory = Inventory turnover ratio
$25,000 / ($100,000 + $60,000)/2 = .31 – Inventory turnover ratio
A .31 ratio means XYZ Company sold only about a third of their inventory during the year. This indicates the company has poor inventory control, which means the purchasing department is not in sync with the sales department.
Inventory Turnover Ratio: ABC Company
Let’s assume ABC Company has a cost of goods sold of $60,000, beginning inventory of $100,000 and ending inventory of $25,000.
The inventory turnover ratio for ABC Company is calculated as follows:
Cost of goods sold / Average inventory = Inventory turnover ratio
$60,000 / ($100,000 + $25,000)/ 2 = .96 – Inventory turnover ratio
A .96 ratio indicates ABC Company sold almost 100% of their inventory during the year. This indicates the company has good inventory control and that stock purchases are in sync with sales.
Reports You Can Generate to Compute Your Inventory Turnover Ratio
You need access to your beginning and ending inventory and cost of goods sold to compute your inventory turnover ratio. If you have accounting software, you can generate with the information you need to calculate your inventory turnover. Namely, the balance sheet reports for the beginning and the end of the period and the profit and loss report for the whole year.
How to Generate a Balance Sheet Report in QuickBooks Online
To generate a balance sheet report in QuickBooks Online, navigate to the Reports menu and select the balance sheet report located in the business overview section. Enter the date and refresh the report.
The following are the steps below to generate a balance sheet statement in QuickBooks Online.
1. Navigate to Reports
From the left menu bar, select Reports as indicated below:
Navigate to Reports in QuickBooks Online
2. Select the Balance Sheet Report
Select the balance sheet report listed in the Business overview reports section, as indicated below:
Select the Balance Sheet in QuickBooks Online
3. Select the date to generate your balance sheet report.
The report below shows information as of January 1, 2019, the beginning of the period:
Sample Balance Sheet Report from QuickBooks Online
4. Change the date range to generate the balance sheet report for the end of the period.
In the example below, we’ve changed the date range to the end of the period, December 31, 2019:
Sample Balance Sheet Report from QuickBooks Online
How to Generate a Profit & Loss Report in QuickBooks Online
To create a profit and loss report in QuickBooks Online, navigate to reports and select the profit and loss report located in the business overview reports section. Enter the date range for the time period you want to run the report for.
Follow the steps below to generate a profit and loss report in QuickBooks Online.
1. Navigate to Reports
From the left menu bar, select Reports as indicated below:
Navigate to Reports in QuickBooks Online
2. Select the Profit & Loss Report
Select the profit and loss report listed in the Business overview reports section, as indicated below:
Select the Profit and Loss Report from the Business overview in QuickBooks Online
3. Select the date range to generate your profit and loss report.
The report below is for the period January 1 to December 31, 2019:
Sample Profit and Loss Report Generated in QuickBooks Online
Inventory Turnover Ratio Example for Paul’s Plumbing Co.
Using the balance sheet and profit and loss reports generated for our fictitious company―Paul’s Plumbing (above)―the inventory turnover ratio is calculated as follows:
Cost of goods sold / (Beginning inventory + Ending inventory) / 2 = Inventory turnover ratio
$32,500 / ($2,750 + $20,250) / 2 = 1.41
A turnover ratio of 1.41 means Paul’s Plumbing sold out of their inventory almost 1.5 times during the year. This indicates Paul’s Plumbing has good inventory control, which means purchases are in line with sales.
Comparing the Inventory Turnover Ratio to the Days Sales of Inventory
Days sales of inventory―also known as days inventory―is the number of days it takes to turn inventory into sales. It’s calculated by taking the average inventory, dividing it by the cost of goods sold, and then multiplying the result by 365 days.
The formula to compute the days sales of inventory (DSI) is:
(Average inventory / Cost of goods sold) x 365 = DSI
DSI Example: Paul’s Plumbing
Let’s say Paul’s Plumbing has an average inventory of $25,000 and $80,000 in cost of goods sold. We will divide the average inventory by cost of goods sold and multiply it by 365 to get the DSI.
The DSI for Paul’s Plumbing is:
($25,000 / $80,000) x 365 = 114 days
It takes Paul’s Plumbing 114 days to sell out of its inventory completely. Depending on what industry this business falls into, this high DSI could hurt Paul’s Plumbing because it may result in additional storage costs or obsolete inventory because it keeps inventory in stock for a long period of time.
Key Takeaways of the Inventory Turnover Ratio
There are three key takeaways you should keep in mind for the inventory turnover ratio. First, this ratio can affect your ability to get approved for a bank loan. Second, what’s consider an appropriate turnover ratio varies by industry. Be sure to compare your ratio to similar companies in your industry. Third, the sales and purchasing departments must work closely together to have good inventory control.
Some key takeaways of the inventory turnover ratio are:
- Inventory turnover ratio can affect your ability to get approved for a loan: Inventory is typically 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 turn the inventory during in a short period of time.
- Inventory turnover ratios vary 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 or homes.
- Sales and purchasing must be in sync: The sales and purchasing departments need to work together to manage inventory. The sales department knows what products are in demand and purchasing is responsible for replenishing stock. If these two departments are not in sync, you will have a hard time meeting customer demand.
Frequently Asked Questions (FAQs) About the Inventory Turnover Ratio
We have included the most frequently asked questions about inventory turnover in this section.
How do you calculate inventory turnover ratio?
The inventory turnover ratio is calculated by dividing the cost of goods sold by the average inventory for the period, generally one year.
The formula to calculate inventory turnover ratio is:
Inventory turnover ratio = Cost of goods sold / Average inventory
What is the ideal inventory turnover ratio?
The ideal ratio varies based on the industry. In most cases, high inventory ratios are ideal because that means your company does a good job of turning inventory into sales. However, sellers of high-end goods may have a less turnover because of the high cost and long manufacturing time.
What is DSI?
DSI is the number of days it takes to turn inventory into a sale. It’s calculated by taking your average inventory and dividing it by the cost of goods sold for the period.
The formula for days sales of inventory is:
Average inventory / Cost of goods sold x 365 = DSI
Bottom Line
Now that you have more insight into how the inventory turnover ratio works, how to calculate it, and what it means, it’s time to see what yours is. If you have accounting software, run your profit and loss and balance sheet reports to get the information you need to compute your ratio. However, if you don’t have accounting software, we recommend QuickBooks Online.
QuickBooks Online not only allows you to generate reports to help you to calculate your inventory turnover ratio, but it can also track all income and expenses for your business. Tracking these in QuickBooks allows you to generate reports that give you insight into sales, profit, and overall performance of your business. Sign up for a free 30-day trial to get started with QuickBooks.
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