What Is It? Why Should You Care?
Inventory turnover ratio is probably one of the best indicators that shows how efficiently your company is turning inventory into sales. The ratio indicates how many times the inventory is sold during a certain periode of time such as a year. Knowing your company’s turnover rate helps to plan future inventory purchases and to optimize stock.
Days in inventory* (DII) helps to understand inventory turnover even better because it puts turnover ratio into daily context. DII value shows the average number of days it takes to sell the current inventory on hand. Generally a higher inventory turnover (but lower inventory turnover period) is preferred, but it varies from one industry to another.
Knowing these numbers is important because they influence a significant source of your profit, the margin. Decrease in inventory turnover means that stock is moving slower and less goods are being sold or you’ve had to lower the markup rate for some reason. This will cause the margin to decline. Investors are interested in knowing how liquid you company’s inventory is and how fast you can turn it into cash. If it can’t be sold, it’s worthless to your company and to potential business partners.
*Also known as days sale of inventory (DSI), days inventory outstanding (DIO), days inventory, inventory period, inventory turnover period, or simply average days to sell the inventory.
It’s Really Simple To Calculate!
Turnover ratio can be calculated by dividing sales or the cost of goods sold (COGS) with the average inventory. Sales and COGS values are on the income statement. Company’s balance sheet reports the inventory on hand. Average inventory can be found by dividing the sum of the beginning value and ending value of the inventory.
Using COGS to find your inventory turnover is more accurate and realistyc as it doesn’t include the markup. On the other hand using sales number is very common and might be necessary for comparative analysis.
Inventory in the beginning of the year: $100 000
Inventory by the end of the year: $120 000
Sales: $1 000 000
COGS: $600 000
Average inventory = (100 000 + 120 000) / 2 = $110 000
Based on sales:
Invenory turnover = sales / average inventory
1 000 000 / 110 000 = 9,09
Days in inventory = time period / inventory turnover = time period x (average inventory / sales)
365 / 9,09 = 365 x (110 000 / 1 000 000) = 40,15 days
Based on COGS:
Inventory turnover = COGS / average inventory
600 000 / 110 000 = 5,45
Days in inventory = time period / inventory turnover = time period x (average inventory / COGS)
365 / 2,27 = 365 x (110 000 / 600 000) = 66,97 days
High Inventory Turnover
- stronger sales and higher profitability
- lower storage risks and less expenses
- reduced need for financial resources for the acquisition of goods
- increase in the solvency
- purchasing is tightly managed
- lower risk of becoming stuck with obsolete stock
- may indicate to inadequate inventory levels
- risk of running out of stock and losing sales to competitors
- can refer to low cash reserves to maintain normal stock levels
- may be due to large discounts that produce no or small profit
Low Inventory Turnover
- low inventory turnover is acceptable in situations where higher stock levels occur in anticipation of upcoming sales, rising prices or expected market shortages
- weaker sales
- excess inventory
- which could suggest poor inventory management or low sales
- it ties up company’s cash and makes it vulnerable
- risk of inventory aging
- flaws in purchasing system
- higher storage charges
- obsolescence or deficiencies in the goods
- can indicate overall marketing problems
DO NOT FORGET!
- Compare your inventory turnover or days in invetory values against industry average.
- Match current turnover rate to previos and planned ratios.
- Only compare inventory turnover that uses the same approach (sales or COGS based).
- Higher turnover is useless unless you make a profit on each sale.
- Make sure you have enough stock with higher inventory turnover, so you won’t lose sales. This might cause increase in expenses and lower your company’s profitability.
- Inventory purchases made in preparation for special sale events can suddenly and sometimes artificially change the inventory turnover rate.