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Inventory Turnover Ratio

What is the inventory turnover ratio? Inventory turnover ratio is an important ratio which shows the number of times a company’s inventory is sold or replaced in a given period. Inventory turnover ratio is also known as stock turns, turns, stock turnover, or inventory turnover. Although, the rule of thumb says that a higher inventory turnover ratio or a shorter inventory period means that the company is performing well; however, we need to compare the ratios or period against industry average and/or historic data of the company to understand the performance.

Inventory turnover ratio is calculated by dividing the cost of goods sold (COGS) by Average inventory. Average inventory is calculated by taking the beginning balance plus ending balance and divide it by two. Inventory turnover ratio can also be in days. To calculate inventory turnover period we simply need to divide 365 by inventory turnover ratio. Below are the equations to find Inventory Turnover, Average Inventory, and Average days to sell the inventory.

Importance in business

Inventory turnover ratio reveals the productiveness of a particular company. A low ratio indicates that the company is poor at handling their inventory. A low inventory turnover can be the result of overstocking or obsolescence in the product. A low inventory turnover ratio will easily lead to higher carrying cost and blocking of capital. On the other spectrum, an extreme high inventory turnover ratio also indicates inadequate performance by a company. A high inventory turn indicates that the company is not closely mentoring the demand of their product line thus buying and turning inventory real fast. A high turnover can indicate that the company has a chance of losing business due to stock shortage. Also, high a turnover leads to higher transactions cost.

Use the Inventory Calculator above to calculate inventory turnover ratio or inventory turnover period.

Example:
A company has Carrying cost of $300,000, direct labor cost to sell its goods $200,000. The company began with $50,000 inventory with hand this year and ended with $200,000 at the end of the year. Calculate the Inventory Turnover Ratio and convert the ratio into days?

Step 1:
Calculate the Cost of Goods Sold
Carrying cost $300,000 + Direct Labor Cost $200,000 = $500,000

Step 2:
Calculate the Average Inventory
Beginning Inventory $50,000 + Ending Inventory $200,000 = $250,000

Step 3:
Calculate the Ratio
Inventory Turnover ratio = Cost of goods sold $500,000 / Average Inventory $250,000
Inventory Turnover Ratio = 2

Step 4:
Calculate the Period
Inventory Turnover Period = 365 days/ Inventory turnover ratio 2 = 182.5 Days

Supplementary Term definition:

Carrying Cost/Holding Cost – Cost associated with holding or carrying inventory such as rent, utility, insurance, theft and any other

Transaction Cost/Buying Cost – Transaction cost is defined as costs associated with buying merchandise such a labor for accounts payable and shipment cost.

Suggested Calculators

Income Statement – Use the template to calculate income Statement
Balance Sheet – Use the template to Calculate Balance Sheet

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