Inventory turnover is one measure of a company's performance and financial health. Low inventory turnovers generally mean a company is holding too much inventory compared to its sales. Decreasing inventory turnover often means sales are decreasing below expected levels, although that is not always the case. Looking at the company's complete financial statements for several periods will help identify whether the decrease in inventory turns is temporary or indicates a long-term problem.
The inventory turnover ratio is calculated by dividing the cost of goods sold for the period by the average inventory for the period. For instance, if cost of goods sold was $10,000 for the quarter and average inventory was $5,000, then $10,000 divided by $5,000 would equal an inventory turnover ratio of 2. Two inventories per quarter means a company takes one and one-half months to use and replenish on-hand inventory
Generally, higher inventory turns equate to higher sales, especially when compared to a competitor in the same market. Inventory turns are also an indicator of how well a company is matching its inventory levels to support its sales. Properly planning production means the company has neither too much or too little inventory on hand.
In a perfect world, a business would end each day with zero inventory by producing exactly what was demanded by the customer each day. Inventory turns have an impact on liquidity, since lower turns mean that more of a company's money is tied up in inventory. Slower-moving inventory increases risk to the company. As inventory ages, the risk of inventory loss, damage or expiration increases.
The most common cause of decreasing inventory turnover is a decrease in sales. When a company has planned and produced a certain level of inventory based on sales forecasts that don't materialize, extra inventory is the result. Decreasing turnover can also be the result of returns from a prior period, extra production to create safety stock against future potential sales increases or fulfillment of a contractual stocking agreement with a customer.
In some cases, a high inventory turnover ratio may not indicate that a company is doing well. It may mean that the company is actually running too low on inventory and losing sales as a result of stock-outs or lengthy lead times. Inventory turns can be artificially inflated for one period based on advance sales or a significantly discounted price. For instance, a clothing brand selling last year's designs for a fraction of their original price may see increased inventory turns but falling profits. This is why it's important to look at several sequential periods of the company's financial statements to understand its true health.