Inventory turnover measures the number of times inventory is sold and replaced during a certain time period. Low inventory turnover ratios are generally undesirable to investors. Low turnover can indicate bad buying practices, faulty inventory management techniques and the presence of obsolete inventory. However, there are a variety of factors that can affect inventory turnover and undermine the usefulness of the ratio. Because of this, there is no specific number that indicates a good inventory turnover ratio, and it should be used in conjunction with other financial analysis.
The company industry has huge effect on the inventory turnover ratio. Industries that sell one-of-a-kind, high-end products are apt to have higher inventory and lower turnover. For example, a high-end jewelry store with custom pieces may take months to sell a certain item. However, this does not necessarily indicate inventory obsolesce, as long as the jewelry does not go out of fashion.
Even companies within the same industry can have wildly different turnover ratios because of their specific selling patterns. For example, inventory needs can vary in electronics companies. An electronics company that sells customized computers direct to consumers will have high inventory turnover, because supplies are only ordered as needed. On the other hand, an electronics company that sells through retailers must have stock on hand at any time, so its inventory turnover will be lower.
Inventory turnover tends to correlate with other financial ratios, like profit margin. Businesses with a low profit margin tend to have high inventory turnover, whereas companies with high profit margin have lower inventory turnover. For example, a high-traffic grocery store will have extremely high turnover ratios on items like bread and milk. However, the store also receives very low margins on these items because of their wide availability and high volume. In this instance, the inventory ratio is very important, because there is a strong chance of inventory obsolescence.
Certain purchasing techniques can inflate the amount of inventory and cause inventory turnover to appear low. However, this doesn't necessarily mean that the purchasing technique is a bad strategy. For example, a purchasing manager may make large purchases on an infrequent basis to take advantage of discounts and sales. As long as the inventory is not at risk of becoming obsolete and the company has a strong understanding of their client needs, this could be a great cost-saving technique.