The inventory turnover ratio is computed by dividing the cost of goods sold by
Definition of Inventory Turnover RatioThe inventory turnover ratio is often calculated by dividing a company's cost of goods sold for a recent year by the average amount of inventory during that year. The result is the average number of times that the company's inventory had been sold. The goal is to have an inventory turnover ratio as large as possible without losing sales and/or customers. Show
Example and Limitations of the Inventory Turnover RatioAs an example, assume that in its recent year a company had sales of $7 million, cost of goods sold (COGS) of $5 million, and an average inventory cost of $1 million. This means the company's inventory turnover was on average 5 (or 5 times) calculated by dividing the COGS of $5 million of cost of goods sold by $1 million of inventory cost. (This indicates that on average the company turned its inventory every 72 days.) A limitation of the inventory turnover is that it is an average, which means that some important details may be hidden. For instance, what if four inventory items make up 40% of the company's sales but make up only 10% of the inventory cost? These fast selling items will have a turnover ratio of 20 (40% of the COGS = $2 million divided by $100,000, which is 10% of $1 million). This means that the remaining items in inventory will have a cost of goods sold of $3,000,000 and their average inventory cost will be $900,000. As a result, the majority of the items in inventory will have an average turnover ratio of 3.3 ($3,000,000 divided by $900,000). In other words, the fast selling items are turning every 18 days (365 days/20) and the majority of the items are turning on average every 109 days (365/3.3). That information is being hidden when the focus is on the average of 72 days. It is also likely there is another group of inventory items that are turning even less than 3.3 times during the year. People within the company can overcome the shortcomings described above by computing the inventory turnover ratio and the days' sales in inventory for each and every item in inventory. By reviewing the turnover ratio for each item, the slow moving items cannot be hidden by the overall turnover ratio. Recommended textbook solutionsEssentials of Investments9th EditionAlan J. Marcus, Alex Kane, Zvi Bodie 689 solutions  Intermediate Accounting14th EditionDonald E. Kieso, Jerry J. Weygandt, Terry D. Warfield 1,471 solutions
Financial Management: Theory and Practice14th EditionEugene F. Brigham, Michael C Ehrhardt 263 solutions Advanced Accounting14th EditionJoe B. Hoyle, Thomas F. Schaefer, Timothy S. Doupnik 1,117 solutions Definition and Examples of Inventory Turnover RatioThe inventory turnover ratio is a simple method to find out how often a company turns over its inventory during a specific length of time. It's also known as "inventory turns." This formula provides insight into the efficiency of a company when converting its cash into sales and profits. For example, a company like Coca-Cola could use the inventory turnover ratio to find out how quickly it's selling its products, compared to other companies in the same industry.
How the Inventory Turnover Ratio WorksYou can save yourself a lot of trouble when finding ITRs by looking at a company's balance sheet and income statement. COGS is often listed on the income statement; inventory balances will be found on the balance sheet. With these two documents, you just need to plug the numbers into the formula. If you compare figures, keep in mind that some analysts use total annual sales instead of the cost of goods sold. This is largely the same equation, but it includes a company's markup. That means it can lead to a different result than equations that use the cost of goods sold. One isn't better than the other, but be sure you are consistent with your comparisons. You don't want to use annual sales to find the ratio for one company while using the cost of goods sold for another. It wouldn't give you any real sense of how the two compare. How Do You Calculate the Inventory Turnover Ratio? The first step for finding the ITR is to choose a time frame to measure (e.g., a quarter or a
fiscal year). Then, find the average inventory for that period. You can do that by averaging the ending and beginning costs of inventory for the time in question. Once you have your time rame and average inventory, simply divide the
cost of goods sold (COGS) by the average inventory. Inventory Turnover Ratio Calculation ExampleConsider this real-world example: Coca-Cola's income statement from 2017 showed that the COGS was $13.256 million. Its average inventory value between 2016 and 2017 was $2.665 million. We can use these figures to find the ratio:
Now you know that Coca-Cola's inventory turns for that year was 4.974. You can compare this to others in the soft drink and snack food industry to figure out how well Coca-Cola is doing. Let's say, for instance, that you found out that a competitor's inventory turns was 8.4. That would signal that the competitor is selling products more quickly than Coca-Cola. There are many reasons why a company may have a lower ITR than another company. It doesn't always mean that one company is worse than the other. Be sure you read a company's financial statements and any notes to get a full picture. Although Coca-Cola's ITR was lower, you might find other metrics that show that it was still stronger than the other averages for its industry. Using historical data to compare current years to past years could also provide helpful context. NoteIn many cases, the more a company's assets are tied up in inventory, the more they rely on faster turnover. Inventory Turnover DaysYou can take this analysis a step further by using the inventory turn rate to find the number of days it takes for a business to clear its inventory. Let's keep going with the Coca-Cola example. In that case, its ITR was 4.974. Next, we divide 365 by that number, which should give a result of 73.38. That means, on average, it took Coca-Cola 73.38 days to sell its inventory. This puts the company's efficiency in another context. Finding the inventory turnover days doesn't provide any new information, but framing it in terms of days is helpful for some. Limitations of the Inventory Turnover RatioThe time it takes a company to sell through its supply can vary greatly by industry. If you don't know the average inventory turns for the industry in question, then the formula won't help you very much. For instance, retail stores and grocery chains typically have a much higher ITR. That's because they sell lower-cost products that spoil quickly. As a result, these businesses require far greater managerial diligence. On the other hand, a company that makes heavy equipment, such as airplanes, will have a much lower turnover rate. It takes a long time to manufacture and sell an airplane, but once the sale closes, it often brings in millions of dollars for the company. Key Takeaways
What is inventory turnover ratio?Inventory turnover measures how efficiently a company uses its inventory by dividing its cost of sales, or cost of goods sold (COGS), by the average value of its inventory for the same period. It is an especially important efficiency ratio for retailers.
What ratio is sales divided by inventory?Sales divided by inventory levels equals inventory turnover. This ratio tells the analyst how many times the inventory sitting in stock has been moved or "turned over" during the average year.
What is a good inventory turnover formula?You can calculate it using the turnover ratio formula: Cost of goods sold (COGS) / average inventory value. So, if your COGS for 2019 totaled $300,000 and your inventory was worth $60,000, your ITR would be 5.
What is the formula for the inventory turnover ratio quizlet?Measures the number of times that inventory is acquired and sold or used during a period; expressed as: Inventory Turnover = Cost of Goods Sold divided by Average Inventory.
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