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. It is an important bookkeeping task that can make a major impact on your business’s success. 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 we also cover in this article.
The inventory turnover ratio formula is:
Inventory turnover ratio = COGS / Average 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 the products or services you sell. If you use accounting software, you can run a profit and loss report to get your COGS figure. You can also use this formula:
COGS = (Beginning inventory + purchases) – 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 ending inventory of $20,000. The COGS for ABC Company is calculated as follows:
($10,000 + $50,000) – $20,000 = $40,000
Tip:
Determining the cost of beginning and ending inventory can be difficult to do by hand and requires a cost-flow assumption. The most common cost-flow assumptions are average cost, first-in, first-out (FIFO), last-in, first-out (LIFO), and specific identification.
Step 2: Calculate Average Inventory
The formula to calculate average inventory is:
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 does not fluctuate a lot, use the ending inventory instead. You can run a balance sheet report to get your inventory numbers.
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 Inventory Turnover Ratio
The inventory turnover ratio is calculated as follows:
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.
$40,000 / $15,000 = 2.67
How To Interpret the Inventory Turnover Ratio
Similar to other financial ratios, the inventory turnover ratio is only one piece of information about a company’s ability to manage its inventory. A comparison to your industry can help you to determine if your turnover ratio is 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 be a signal of 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 or possibly excess inventory, or even that there is 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 out what the standard ratio is for your industry so that you can compare your ratio to similar businesses.
Inventory Turnover Ratio Examples
In this section, we will demonstrate how to calculate inventory turnover by walking through a few examples. We also included a brief explanation of what the inventory turnover ratio means for the business.
Example 1: Inventory Turnover Ratio for XYZ Company
XYZ Company had the following results last year:
- COGS: $25,000
- Beginning inventory: $100,000
- Ending inventory: $60,000
The inventory turnover ratio for XYZ Company is calculated as follows:
$25,000 COGS / [($100,000 Beginning inventory + $60,000 Ending inventory) / 2] = .31 Inventory turnover ratio
A .31 ratio means XYZ Company sold only about a third of its inventory during the year. Determining whether this is a low or high ratio depends on the type of business. If XYZ Company is a bookstore, this number would indicate that it has poor inventory control, which means the purchasing department is not in sync with the sales department. However, if it is a company that sells high-ticket items, such as cars or houses, a lower ratio might make more sense.
Example 2: Inventory Turnover Ratio for ABC Company
ABC Company had the following results last year:
- COGS: $200,000
- Beginning inventory: $50,000
- Ending inventory: $50,000
The inventory turnover ratio for ABC Company is calculated as follows:
$200,000 COGS / [($50,000 Beginning inventory + $50,000 Ending inventory) / 2] = 4 Inventory turnover ratio
A 4 ratio indicates ABC Company sold its inventory every quarter. This might be good for a car dealership, as it means the company has good inventory control and that stock purchases are in sync with sales.
Key Takeaways of the Inventory Turnover Ratio
There are three key takeaways you should keep in mind 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 in a short period of time.
- 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 knows what products are in demand, and purchasing is responsible for replenishing stock. If these two are not in sync, you will have a difficult time meeting customer demand without investing too much cash in unnecessary levels of inventory.
Frequently Asked Questions (FAQs)
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 lower turnover ratios because of the high cost and long manufacturing time.
What is the difference between inventory turnover ratio and days sales of inventory?
The inventory turnover ratio measures how many times the inventory is sold and replaced over a given period. Days sales of inventory―also known as days inventory―is the number of days it takes to turn inventory into sales.
The formula for days sales of inventory is:
Days sales of inventory = (Average inventory / COGS) x 365
Bottom Line
The inventory turnover ratio shows how many times 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.