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.
Aspect | Explanation |
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Concept Overview | The Inventory Turnover Ratio, also known as the Inventory Turnover or Stock Turnover Ratio, is a financial metric used by businesses to assess how efficiently they manage their inventory. It measures the number of times a company’s inventory is sold and replaced during a specific period, usually a year. A high inventory turnover ratio indicates efficient inventory management, while a low ratio may suggest issues with overstocking or slow sales. |
Formula | The formula to calculate the Inventory Turnover Ratio is: Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory Where: – COGS represents the cost of goods sold during the period. – Average Inventory is the average value of inventory held during the same period, typically calculated as (Beginning Inventory + Ending Inventory) / 2. |
Interpretation | The Inventory Turnover Ratio can be interpreted as follows: – High Ratio: A high ratio (e.g., above 5) indicates that inventory is sold quickly, suggesting efficient inventory management and strong sales. – Low Ratio: A low ratio (e.g., below 2) implies slower inventory turnover, which may be due to overstocking, slow sales, or obsolete inventory. – Industry Comparison: The interpretation may also depend on the industry, as some industries naturally have slower inventory turnover than others. |
Applications | The Inventory Turnover Ratio is applied in various business contexts: – Financial Analysis: It is used by investors and analysts to assess a company’s financial health and efficiency. – Inventory Management: Businesses use the ratio to optimize inventory levels and reduce carrying costs. – Supplier Relationships: It influences decisions related to supplier relationships and procurement. – Operational Efficiency: It helps in evaluating the efficiency of the production and sales processes. – Working Capital Management: It impacts working capital requirements, as excessive inventory ties up cash. |
Benefits | Utilizing the Inventory Turnover Ratio offers several benefits: – Efficiency Assessment: It provides insight into how efficiently a company manages its inventory resources. – Identifying Issues: A declining ratio may indicate problems such as overstocking, slow sales, or obsolete inventory. – Decision Making: It aids in decision-making related to inventory ordering, production planning, and pricing strategies. – Investor Insight: Investors use the ratio to evaluate a company’s financial performance and investment potential. – Cash Flow Improvement: Optimizing inventory turnover can free up cash for other business needs. |
Challenges | Challenges in using the Inventory Turnover Ratio include the need for accurate data, potential variations in inventory valuation methods, industry-specific considerations, and the fact that a high ratio may also result from deep discounts or fire sales. Additionally, seasonal fluctuations can impact the ratio. |
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
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.
Source: reuters.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:
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:
For years, Amazon has barely been profitable, yet it generated cash flows thanks to this strategy in line with its overall business model.
Key Highlights
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Definition and Purpose: The inventory turnover ratio is a financial metric used to measure how efficiently a company converts its inventories into cash during a specific period. It helps assess the effectiveness of inventory management and the speed at which inventory is sold and replaced.
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Calculation Methods: The ratio can be calculated using either of two methods:
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Inventory Components: Inventories comprise various items, including:
- Raw Materials Inventory: Materials needed for production, valued based on FIFO or weighted average price.
- Work in Progress Inventory: Partially assembled goods, valued higher due to ongoing business operations.
- Finished Goods Inventory: Fully assembled products, valued at net realizable value.
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Cost of Goods Sold (COGS): COGS represents the cost incurred to transform inventory into finished products ready for sale. It includes direct costs like materials and labor required for production.
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Interpretation and Analysis: A higher inventory turnover ratio generally indicates efficient inventory management. However, the ratio should be compared over time and against industry benchmarks for a meaningful assessment.
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Inventory Turnover in Days: To understand how quickly inventories are converted into sales, the ratio can be translated into days. This is done by dividing 365 by the inventory turnover ratio.
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Application to Business Models: Companies like Amazon utilize different inventory management strategies based on their business models. Amazon’s lower inventory turnover ratio is attributed to its focus on generating short-term liquidity and reinvesting in operations.
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Importance of Context: The inventory turnover ratio isn’t a standalone measure; it’s valuable when considered in comparison to historical data and industry peers.
Related Frameworks, Models, or Concepts | Description | When to Apply |
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Inventory Turnover Ratio | The Inventory Turnover Ratio measures the efficiency of a company’s inventory management by comparing the cost of goods sold (COGS) to the average inventory level during a specific period. It indicates how many times a company’s inventory is sold and replaced within a given time frame. A high inventory turnover ratio suggests efficient inventory management, while a low ratio may indicate excess inventory levels or slow-moving inventory. | Apply the Inventory Turnover Ratio to evaluate the effectiveness of inventory management practices. Use it to assess inventory turnover trends over time, identify opportunities to improve inventory control and reduce carrying costs, and optimize inventory levels to meet customer demand while minimizing excess inventory and stockouts. Implement inventory turnover analysis to enhance cash flow, profitability, and operational efficiency in supply chain and inventory management processes. |
Just-In-Time (JIT) Inventory Management | Just-In-Time (JIT) Inventory Management is a system for inventory control that aims to minimize inventory holding costs by synchronizing production and inventory levels with customer demand. JIT systems rely on close coordination with suppliers, efficient production processes, and flexible scheduling to deliver goods and materials exactly when needed, reducing the need for excess inventory and storage space. JIT principles emphasize waste reduction, quality improvement, and continuous process improvement. | Apply Just-In-Time (JIT) Inventory Management to optimize inventory levels and reduce holding costs. Use JIT principles to synchronize production and inventory levels with customer demand, minimize lead times and production bottlenecks, and improve operational efficiency and responsiveness in supply chain and manufacturing processes. Implement JIT practices to streamline inventory management, reduce waste, and enhance competitiveness in dynamic and competitive markets. |
Economic Order Quantity (EOQ) | Economic Order Quantity (EOQ) is a model for determining the optimal order quantity that minimizes total inventory costs, including ordering costs and carrying costs. EOQ analysis considers factors such as demand variability, order lead time, and inventory carrying costs to calculate the ideal order quantity that balances the costs of ordering and holding inventory. EOQ models help companies optimize inventory levels, reduce stockouts, and minimize inventory holding costs while ensuring adequate inventory availability. | Apply Economic Order Quantity (EOQ) analysis to determine the optimal order quantity for inventory replenishment. Use EOQ models to minimize total inventory costs by balancing ordering and carrying costs, optimize order frequency and batch sizes to meet demand requirements while minimizing excess inventory and storage costs, and improve inventory control and management efficiency in procurement and supply chain operations. Implement EOQ calculations to enhance inventory planning, reduce costs, and improve cash flow and profitability. |
ABC Analysis | ABC Analysis is a technique for classifying inventory items based on their relative importance and value to the organization. ABC classification categorizes inventory into three groups: A items (high-value items with low frequency), B items (moderate-value items with moderate frequency), and C items (low-value items with high frequency). ABC analysis helps companies prioritize inventory management efforts, allocate resources effectively, and focus attention on the most critical inventory items. | Apply ABC Analysis to prioritize inventory management efforts and allocate resources efficiently. Use ABC classification to identify high-value and high-impact inventory items that require close monitoring and control, segment inventory by value and demand variability to tailor inventory management strategies and policies, and optimize inventory levels and service levels to meet customer needs while minimizing costs and risks. Implement ABC analysis to enhance inventory visibility, control, and performance in supply chain and logistics operations. |
Supply Chain Optimization | Supply Chain Optimization involves streamlining and improving the efficiency of supply chain processes to minimize costs, reduce lead times, and enhance customer satisfaction. Supply chain optimization encompasses activities such as demand forecasting, inventory planning, procurement, production scheduling, transportation management, and distribution logistics. By optimizing supply chain processes, companies can improve inventory management, reduce waste, and increase responsiveness to customer demand while minimizing supply chain risks and disruptions. | Apply Supply Chain Optimization to improve inventory management and reduce supply chain costs and risks. Use optimization techniques such as demand forecasting, inventory modeling, and production planning to synchronize supply and demand, minimize inventory levels and stockouts, and improve inventory turnover and service levels. Implement supply chain optimization strategies to enhance agility, efficiency, and competitiveness in dynamic and complex supply chain environments. |
Lead Time Reduction | Lead Time Reduction involves minimizing the time required to fulfill customer orders and replenish inventory by reducing order processing times, production lead times, and transportation lead times. Lead time reduction initiatives focus on improving supply chain visibility, collaboration, and coordination among suppliers, manufacturers, and distributors to accelerate order fulfillment and delivery cycles. By reducing lead times, companies can improve inventory turnover, increase customer satisfaction, and gain a competitive advantage in the marketplace. | Apply Lead Time Reduction strategies to accelerate order fulfillment and improve inventory turnover. Use lead time reduction initiatives to streamline supply chain processes, eliminate bottlenecks and delays, and improve communication and collaboration with suppliers and partners to expedite order processing and delivery. Implement lead time reduction projects to enhance agility, responsiveness, and customer service in supply chain and logistics operations. |
Vendor Managed Inventory (VMI) | Vendor Managed Inventory (VMI) is a collaborative inventory management strategy in which suppliers take responsibility for managing inventory levels and replenishment decisions on behalf of their customers. VMI arrangements involve sharing demand and inventory data between buyers and suppliers, allowing suppliers to proactively monitor inventory levels and automatically replenish stock when needed. VMI helps companies reduce inventory holding costs, minimize stockouts, and improve supply chain efficiency and visibility. | Apply Vendor Managed Inventory (VMI) to improve inventory management and reduce inventory holding costs. Use VMI partnerships to delegate inventory management responsibilities to suppliers, streamline order processing and replenishment, and improve supply chain responsiveness and reliability. Implement VMI programs to optimize inventory levels, reduce stockouts, and enhance collaboration and efficiency in supply chain and logistics operations. |
Safety Stock Optimization | Safety Stock Optimization involves determining the appropriate level of safety stock or buffer inventory to protect against uncertainty and variability in demand, supply, and lead times. Safety stock represents additional inventory held as a precautionary measure to mitigate the risk of stockouts and disruptions due to unexpected fluctuations in demand or supply. Safety stock optimization aims to balance the trade-off between service level requirements and inventory holding costs while ensuring adequate inventory availability to meet customer demand. | Apply Safety Stock Optimization to enhance inventory management and mitigate supply chain risks. Use safety stock optimization techniques to calculate the optimal level of buffer inventory needed to achieve desired service levels and minimize stockouts, assess demand variability, lead time uncertainty, and supply chain reliability to determine safety stock requirements, and develop contingency plans and risk mitigation strategies to maintain inventory availability and customer satisfaction. Implement safety stock optimization strategies to improve resilience and responsiveness in supply chain and logistics operations. |
Cycle Counting and Inventory Accuracy | Cycle Counting and Inventory Accuracy involve regularly auditing and verifying inventory levels and accuracy through periodic cycle counts and inventory reconciliation processes. Cycle counting entails counting a subset of inventory items on a regular basis, rotating through different inventory locations and items over time, to ensure that inventory records and physical inventory levels align. By maintaining accurate inventory records and conducting regular cycle counts, companies can reduce discrepancies, improve inventory accuracy, and enhance supply chain reliability and efficiency. | Apply Cycle Counting and Inventory Accuracy practices to improve inventory management and control. Use cycle counting techniques to systematically verify inventory levels and accuracy, identify discrepancies and errors in inventory records, and reconcile physical inventory with system data to improve inventory accuracy and reliability. Implement cycle counting programs and inventory reconciliation processes to enhance inventory visibility, reduce shrinkage and stockouts, and optimize inventory management practices in supply chain and warehouse operations. |
Inventory Optimization Software | Inventory Optimization Software encompasses a range of software tools and systems designed to help companies optimize inventory levels, streamline inventory planning and replenishment processes, and improve supply chain visibility and control. Inventory optimization software may include demand forecasting modules, inventory planning algorithms, reorder point calculators, and inventory optimization models that use data analytics and machine learning to optimize inventory decisions and strategies. By leveraging inventory optimization software, companies can enhance forecasting accuracy, reduce excess inventory, and improve inventory turnover and service levels. | Apply Inventory Optimization Software to automate and improve inventory management processes. Use inventory optimization software to analyze historical sales data, forecast future demand, and calculate optimal inventory levels and reorder points, automate inventory replenishment and procurement decisions, and optimize inventory policies and strategies to minimize costs and maximize service levels. Implement inventory optimization software to enhance decision-making, efficiency, and competitiveness in supply chain and inventory management operations. |
Other Amazon case studies:
- How Amazon Makes Money: Amazon Business Model in a Nutshell
- Amazon Case Study: Why from Product to Subscription You Need to “Swallow the Fish”
- What Is Cash Conversion Cycle? Amazon Cash Machine Business Model Explained
What Is the Receivables Turnover Ratio? How Amazon Receivables Management Helps Its Explosive Growth
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