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.
Table of Contents
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.Â
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.Â
Inventories will be valued according to the ânet realizable valueâ 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.Â
Raw materials inventoriesÂ
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.Â
In conclusion, they will have a higher value, although very subjectively determined.
Finished goods inventoryÂ
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.
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.
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.
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.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 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, Â Amazon AWS, Subscription Services, Advertising revenues, and Physical Stores.
Key HighlightsÂ
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.
Calculation Methods: The ratio can be calculated using either of two methods:
Sales / Average Inventory: Dividing total sales by the average inventory value.
Cost of Goods Sold (COGS) / Average Inventory: Dividing COGS by the average inventory value.
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.
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.
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.
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.
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.
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.
The circle of competence describes a personâs natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term âmoatâ referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that countryâs GDP. Itâs a measure and ratio to evaluate whether a market is undervalued or overvalued. Itâs one of Warren Buffetâs favorite measures as a warning that financial markets might be overvalued and riskier.
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the companyâs capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.
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.
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).
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).
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.
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 endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as 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 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.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both.
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
