inventory-turnover-ratio

What Is the Inventory Turnover Ratio? How Inventory Efficiency Can Fuel Business Growth

The inventory turnover ratio is a financial metric that tells you how many times throughout a period the company converted its inventories into cash for the business. In fact, that can be calculated either by dividing the sales by the average stock or by dividing the cost of goods sold by the average inventory.

How to calculate the inventory turnover ratio?

In the next paragraphs, we’ll look at the components you need to understand to calculate the inventory turnover ratio.

What is an inventory?

The inventory is a list of goods a company has on hand to be sold. That is a broad definition as the inventory composition can vary based on the business and industry.

Imagine the scenario in which we have a company who sells smartphones; the production gets outsourced. 

Therefore, your inventories will be mainly comprised of finished products.

Imagine the opposite scenario. The company manufactures smartphones. Therefore, the inventories will be comprised of the finished product (smartphones), but also and mainly of components.

As you can imagine the value of the inventories from the first to the second scenario will be slightly different. 

Inventories will be valued according to the “net realizable value” or the amount for which the goods can be sold for after subtracting the expenses incurred to make the sales.

As we saw from the example above, if you own a company who manufactures smartphones, the inventories will be comprised of three kinds of goods that can be valued accordingly.

We can classify the inventories based on how close they are to being sold. A raw material, for instance, if yet in a state that can’t be sold. In fact, that needs to be processed to become a final product. 

Raw materials inventories 

Typically they include materials that have different values.

Example: Imagine, your inventory comprises phone screens. As technology progresses the price of some components decreases.

Therefore, your inventory comprises phone screens that range from one year ago up to three months ago.

Further, the batches acquired one year ago are valued at $10 per piece while the newly acquired are valued at $8 per piece.

Two methodologies can be used in this case: either the FIFO or the weighted average price. The former means First in, First out.

Practically the Inventory will be valued at the price of the latest goods received, in our example $8 per unit.

In the latter, the price of the goods will be averaged out. For example, the two batches comprise the same number of items or 50 items at $10 in the first batch and 50 items at $8 in the second batch.

Therefore, the weighted average formula will be: ((50 x $8)+(50 x $10))/100 = $9 per unit. In conclusion, according to FIFO the value of your inventory will be $800 or $8 x 100 while according to the weighted average will be $900 or ((50 x $8)+(50 x $10)) x 100).

Work in progress inventory

In the real world, these items may be considered worthless. Imagine your inventories are comprised of not fully assembled smartphones, either because the screen is missing or the CPU has not been completed yet.

How would you value them from the accounting perspective? Well, do you remember what does the going concern principle state?

According to this principle, accountants assume the business will continue the operations in the foreseeable future.

Therefore, in our example, the smartphone not fully assembled will be valued more in comparison to the raw materials, since the assumption is that the business will continue the operations long enough to sell the finished product eventually.

Furthermore, the value of the work in progress stock will include things such as the labor costs incurred in the manufacturing process. 

In conclusion, they will have a higher value, although very subjectively determined.

Finished goods inventory 

They are the most valuable items in the inventory as they might comprise finished goods, which can be valued at the net realizable value.

There is another element to take into account for the sake of the inventory turnover ratio formula: the cost of goods sold.

What is the cost of goods sold (COGS)?

The cost of goods sold represents the cost incurred to turn the inventory in a finished product ready to be sold.

That includes direct costs of materials and labor for processing the inventory and make it translate into the finished product ready for sales.

That’s why the cost of goods sold is also called cost of sales. There is no way you can sell what you have in your inventory (unless you have the finished product) before it gets processed or you acquire the materials needed to build it.

Inventory turnover ratio explained

The main aim of the inventory turnover ratio is to have a clear metric that can tell you how fast you convert your current assets (assets that can be converted in cash within a year) in cash that can be used to grow the business.

For the sake of this discussion, we’ll take as inventory turnover formula the cost of goods sold and divide it by the average inventory.

Why? That measure is more accurate. In fact, the inventories stay tied to the cost of goods sold, way more than the revenues.

In fact, in the net sales number, you’ll have things like the markup which do not allow us to have a complete overview of the inventory management.

Inventory turnover ratio formula

Cost of goods sold / average inventory = how many times the inventory is sold

Let’s take the example in which a company has spent $300K in direct costs of materials and labor to produce the finished products.

Imagine now that company has an inventory value of $30k. How much would its inventory turnover ratio be?

$300K / $30K = 10 times

That means the company can convert its inventory in finished products that get sold ten times in a year (if we compute it on a yearly basis).

How can we interpret it?

Inventory turnover ratio interpretation

The inventory turnover ratio can help us assess if a company is efficiently managing its inventories. In short, if it is converting them fast enough in finished products that get sold to grow the business.

In general, the higher the number, the better. However, financial management metrics can tell us something only when we do at least two kinds of comparison: first, what is the value of the inventory turnover ratio compared to the previous years. Second, how the inventory turnover ratio compares to the same industry.

What is a good inventory turnover ratio?

Finding an optimal inventory turnover ratio is critical. Yet there is no fixed number. Of course the higher the inventory turnover, the better.

It is essential to keep in mind that the inventory turnover ratio is not an end in itself but it needs to help you assess several parts of the business that affect this number.

Comparing it with the previous years and the competition is a sound methodology.

Yet when the inventory turnover ratio becomes too low, you want to look at several factors that might be affecting it.

For instance, sales processes, suppliers contracts, and relationships, or inventory management systems are all way to tackle a low inventory turnover.

How the inventory turnover ratio is connected to the receivables turnover

Things like accounts receivable accounts payable and inventories comprise the so-called current assets.

The way you manage your current assets is critical to the long-term success of the business as you might end up lacking the short-term liquidity to run the operations.

Thus, things like the receivables turnover ratio, combined with inventory and payable turnover ratio make up the so-called cash conversion cycle. Companies like Amazon have built their success on a successful cash conversion cycle management.

Think of the case in which you manage to have low inventory at hand, while get paid fast by your customers and managed to have an extension in terms of payments toward your suppliers.

This scenario would unlock liquidity in excess that you can use to grow your business.

Inventory in days

With a simple additional step, we can assess how long it takes for a company to convert its inventories in sales.

You can do that by taking 365 (number of the days in a year) and dividing it by the inventory turnover ratio:

Inventory in days formula

365 / inventory turnover ratio = number of days to convert inventories in the sold product

For instance, Amazon has an inventory turnover ratio of 9.84. If we divide 365 by 9.84, we get 37 days.

In other words, it gets 37 days for Amazon to convert its inventories in selling products that give cash to the business operations!

Inventory turnover ratio and inventory in days infographic

inventory-turnover-ratio

Amazon inventory management case study

In fact, the way the inventory gets managed is highly dependent on the industry.

However, as technology can help companies like Amazon and its business model to run with the low inventory at hand, those companies can gain competitive advantages over their competitors.

amazon-inventory-turnover-ratio

Sourcereuters.com

From the analysis of Reuters, you can see how Amazon inventory turnover ratio compared to the sector is way lower.

This is a critical element of Amazon’s overall business strategy. Indeed, Amazon uses what is called a cash machine business strategy:

cash-conversion-cycle-amazon
The cash conversion cycle (CCC) is a metric that shows how long it takes for an organization to convert its resources into cash. In short, this metric shows how many days it takes to sell an item, get paid, and pay suppliers. When the CCC is negative, it means a company is generating short-term liquidity.

In other words, Amazon is able to generate cash from its operations. Since the early 2000s (probably since the start) instead of distributing that cash as a dividend to shareholders.

Amazon has used the extra cash to improve its operations on the one hand and passed it over to customers as lower prices thanks to an improved cost structure. This allowed Amazon to host third-party stores which speeded up the selection and variety of products available on Amazon.com.

This is the logic and power of Amazon Flywheel, which internally they called Virtuous Cycle, this flywheel has been driving Amazon’s growth for years:

amazon-flywheel
The Amazon Flywheel or Amazon Virtuous Cycle is a strategy that leverages on customer experience to drive traffic to the platform and third-party sellers. That improves the selections of goods, and Amazon further improves its cost structure so it can decrease prices which spins the flywheel.
is-amazon-profitable
Amazon was profitable in 2021. The company generated over $33 billion in net income, primarily driven by the Amazon AWS business, which contributed to over 55% of its operating margins and other profitable parts like Amazon Prime and Ads. The Amazon e-commerce platform runs at tight operating margins since it’s built for scale.

For years, Amazon has barely been profitable, yet it generated cash flows thanks to this strategy in line with its overall business model.

amazon-business-model
Amazon has a diversified business model. In 2021 Amazon posted over $469 billion in revenues and over $33 billion in net profits. Online stores contributed to over 47% of Amazon revenues, Third-party Seller Services,  Amazon AWS, Subscription Services, Advertising revenues, and Physical Stores.

Other Amazon case studies:

Other resources for your business:

Read next:

Connected Business Concepts

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowments from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as a fixed asset, with a longer-term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

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