Inventory Turnover Ratio

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
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.

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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.

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:

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:

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.

Key Highlights

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.