Financial ratios measure a company's financial health and its cost efficiencies, profitability and ability to grow sales. Inventory is a balance sheet item that tracks goods available for sale. The inventory turnover ratio measures how often a company moves its inventory out of its warehouse and stores to its customers. A high turnover ratio indicates managerial efficiency.
The inventory turnover ratio is equal to the cost of goods sold divided by the average inventory. The cost of goods sold is equal to the beginning inventory plus purchases during a period minus the period-ending inventory. An accounting period could be a month, quarter or year. The average inventory is equal to the beginning inventory plus the ending inventory divided by two. Managing production levels, driving costs lower and sales higher, and removing obsolete inventory items are some of the ways to increase the inventory turnover ratio.
According to the AccountingTools website, certain manufacturing processes result in a higher inventory turnover ratio. For example, in just-in-time manufacturing, companies buy items as they are required, which means there is never too much inventory on hand. This decreases the denominator in the inventory turnover equation and thus increases the ratio. Companies could plan short production runs, which also means that they would not need to keep excess inventory on hand. Management should use information management systems, such as enterprise planning systems, and historical sales data to forecast accurately end customer demand. This leads to lower levels of inventory and increased inventory turnover ratios.
Costs and Sales
Companies can increase the inventory turnover ratio by driving input costs lower and sales higher. Cost management lowers the cost of goods sold, which drives profitability and cash flow higher. Reducing supplier lead times could also increase turnover ratios. Lowering purchase prices might be easier during a weak economy because suppliers might be willing to use surplus capacity at lower prices. Driving sales growth also could increase the inventory turnover ratio because the company will have lower levels of inventory at hand to start and end a period. However, companies should keep a minimum level of inventory to satisfy customer demand, especially during busy selling periods.
Companies can also increase the inventory turnover ratio by routinely inspecting the inventory and liquidating surplus and obsolete inventory. Companies usually cannot use these inventory items to make other goods or sell them to customers. Therefore, removing these items frees valuable warehouse space for faster-moving items, lowers the ending inventory and increases the inventory turnover ratio.
- NetMBA: Financial Ratios
- AccountingTools; What Is Inventory Turnover?; Steven Bragg; February 2011
- Tompkins Associates; Seven Tips for Managing Inventory Turnover; Ralph Cox
- U.S. Securities and Exchange Commission. "Beginners' Guide to Financial Statements." Accessed Feb. 23, 2020.
- Walmart. "2019 Annual Report: Defining the Future of Retail," Pages 3, 30, & 50. Accessed Feb. 23, 2020.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.