What Is This and Why Should You Care?
The inventory turnover ratio is probably one of the best indicators of company efficiency. Showing how quick you are at turning inventory into sales. The ratio indicates how many times certain inventory is sold during a certain period of time, a year, for example. Knowing and understanding your company’s turnover rate can be a massive help in planning your future inventory purchases and optimizing your stock.
Days in inventory* (DII) can help you to understand your inventory turnover even better because it places the turnover ratio into daily context. The DII value shows the average number of days it takes to sell the current inventory. Generally speaking, a higher inventory turnover (but a lower inventory turnover period) is preferable, but this can vary from one industry to another.
Knowing these numbers is important because they can be a massive influence on your profit margins. A decrease in inventory turnover can mean that 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 always interested in knowing how fluid your company’s inventory is and how fast you can turn that into cash. If inventory can’t be sold it’s effectively worthless.
It’s Really Simple To Calculate!
Turnover ratio can be calculated by dividing sales or the cost of goods sold (COGS) by the average inventory. Sales and COGS values can be found on the income statement. The company’s current inventory can be found on the balance sheet. The average inventory can be found by dividing the sum of the beginning value and ending value of the inventory.
Because it doesn’t include the markup, using COGS to find your inventory turnover makes the results much more realistic. On the other hand, using the number of sales very common and might be necessary for comparative analysis.
The inventory at the beginning of the year: $100,000
The inventory at the end of the year: $120,000
Average inventory = (100,000 + 120,000) / 2 = $110,000
Based on sales:
Inventory 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 vs. Low Inventory Turnover — Pros and Cons
High Inventory Turnover
- Stronger sales and higher profitability
- Lower storage risks and less expenses
- Reduced need for financial resources for the acquisition of goods
- An increase in the solvency
- Purchasing is tightly managed
- A lower risk of becoming stuck with obsolete stock
- May be an indication of 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 only small profit
Low Inventory Turnover
- A low inventory turnover is acceptable in situations where you have built up higher stock levels in anticipation of upcoming sales, rising prices or expected market shortages
- Weaker sales
- An excess of inventory
- …which could suggest either poor inventory management or low sales
- It ties up company’s cash and makes it more vulnerable
- There’s a risk of inventory aging
- Flaws in purchasing system
- Higher storage charges
- Obsolescence or deficiencies in the goods
- Can indicate overall marketing problems
Tips to help you be awesome:
- Compare your inventory turnover, or days in inventory values against the industry average.
- Match your current turnover rate to previous/planned ratios.
- Only compare inventory turnover that uses the same approach as you (sales or COGS based).
- Having a high turnover is useless unless you’re making profit from sales
- Make sure you have enough stock with a higher inventory turnover – this will help you avoid losing out on sales.
- Inventory purchases made in preparation for special sale events can suddenly and sometimes artificially change the inventory turnover rate.
*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.
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