The inventory turnover ratio of a company is a major focus of effective management. It is an important metric that has significant implications for other aspects of the business. The turnover ratio cannot be too high or too low without having a negative impact on a company.
What is the Inventory Turnover Ratio?
The inventory turnover ratio is a measure of how efficiently the inventory of a company is being managed. It measures the number of times the average inventory is "turned" or sold during a specific timeframe. For example, a company with sales of $100,000 and an average inventory of $10,000 would have a turnover of 10 times.
Inventory is the first step in a company's cash flow cycle. The business buys inventory, sells the products, collects the accounts receivable and returns the inventory to cash. The turnover ratio measures how quickly a company can go through this cycle and convert its inventory into cash.
Inventory turns are different for all industries. For example, a shoe retailer will have a higher turnover than an exotic car dealer. An airplane manufacturer will have a much lower turnover than a grocery store. For perspective on how efficiently the inventory is managed, the ratio of a company should be compared to the industry average.
Formula for Inventory Turnover
The following is the formula to calculate inventory turnover:
Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory
The average inventory level is used in this formula because the amount of inventory of many businesses can vary greatly during the year. As an example, the inventory for retailers will be low during the early months of the year and get higher during the holidays at the end of the year.
For most businesses, the average inventory can be calculated by taking the inventory at the beginning of the year and the end and averaging the two amounts. The cost of goods sold will come from the income statement.
Analysis of High Inventory Turnover
Since inventory turnover is a measure of efficiency, a high turnover is important. It shows that the business is buying the most salable products and selling the inventory it has on hand. A more rapid turnover also means the company will have a higher return on equity and return on assets.
However, if the turnover is too high, this could mean that the company is losing sales by not having enough inventory on hand. Dissatisfied customers may lead to a loss of the customer base and declining sales in the next year.
When a company has a line of credit with a bank, it is often secured by a lien on the inventory as collateral. If the company defaults on the loan, bankers need to know they can sell the repossessed products. A higher turnover ratio gives them more peace of mind.
Significance of a Low Inventory Ratio
A low inventory turnover means that the company could have poor sales, overstocked inventory or a product mix that customers don't want. Inadequate sales can be the result of inflated prices, poor quality, ineffective advertising or obsolete products. Excess inventory increases the costs of storage, insurance and security, and losses from theft.
Inventory Turnover Period
A convenient metric is to convert the inventory turnover ratio into the number of days of inventory on hand. To do this, divide 365 days by the turnover ratio. For example, if the inventory turnover is 10 times/year, then the number of days is 365/10 equals 36.5 days. This means that the company is selling its complete inventory every 36.5 days. A comparison to industry averages will give a view on whether the number of days inventory is normal or not.
Inventory comprises a major investment for most businesses, making efficient management a high priority. Maintaining a proper inventory turnover ratio is a tightrope walk between having too much or too little inventory. There are advantages and disadvantages to both extremes.