What is Inventory Turnover?
The inventory turnover ratio measures the rate at which a company purchases and resells products to customers. There are two formulas for inventory turnover:
Sales OR Cost of Goods Sold
Inventory Average Inventory
The first formula is considered to be more common. The second formula accommodates the fact that sales are recorded at market value while inventory is recorded at cost, and its use of average inventory smoothes the effects of seasonal inventory changes. Because there are two formulas, it is important to be clear about which is being used when comparing inventory turnover ratios.
Inventory Turnover Ratio -- Formula & Example
Let's assume Company XYZ reported the following information:
Last Year This Year
Revenue $1,000,000 $1,500,000
Cost of Goods Sold $500,000 $600,000
Inventory $95,000 $100,000
Using the first formula and the information above, we can calculate that Company XYZ's inventory turnover ratio this year was:
$1,500,000 / $100,000 = 15 times
Using the second formula, Company XYZ's inventory turnover ratio this year was:
$600,000 / ($95,000 + $100,000) / 2 = 6.15 times
This means that Company XYZ effectively replenished its inventory 15 times (or 6.15 times) during the course of the year.
Why do Inventory Turnover Ratios matter?
In general, low inventory turnover ratios indicate a company is carrying too much inventory, which could suggest poor inventory management or low sales. Excess inventory ties up a company's cash and makes the company vulnerable to drops in market prices. Conversely, high inventory turnover ratios may indicate a company is enjoying strong sales or practicing just-in-time inventory methods. High inventory turnover also means a company is replenishing cash quickly and has a lower risk of becoming stuck with obsolete inventory. However, higher is not always better, and exceptionally high inventory turnover may indicate a company is running out of items frequently or making ineffective purchases and therefore losing sales to competitors.
It is important to understand that the timing of inventory purchases, particularly those made in preparation for special promotions or new-product introductions, can suddenly and somewhat artificially change the ratio.
Different choices in inventory accounting methods can also affect inventory turnover ratios. In periods of rising prices, companies using the last-in-first-out (LIFO) inventory method show higher costs of goods sold and lower inventories than companies using the first-in-first-out (FIFO) method. Thus, LIFO companies generally report higher inventory turnover ratios than FIFO companies, even when the companies are very similar. Additionally, companies using LIFO also tend to carry more inventory than FIFO companies; the LIFO method increases cost of goods sold, which reduces profits and in turn lowers tax liabilities.
Inventory turnover ratios vary by company as well as by industry. Low-margin industries tend to have higher inventory turnover ratios than high-margin industries because low-margin industries must offset lower per-unit profits with higher unit-sales volume.
For all of these reasons, comparison of inventory turnover ratios is generally most meaningful among companies within the same industry, and the definition of a 'high' or 'low' ratio should be made within this context.