Inventory Turnover Ratio

What is Inventory Turnover ratio ?

Inventory turnover ratio is an efficiency ratio used to measure how efficiently a company is able to sell and replace its inventory in a year. It is number of times a company restocks its inventory in a year. It is obtained by dividing cost of goods sold by the Average Inventory.

It helps the company in arriving at the amount of Inventory that is needed to run its business efficiently without running out of inventory.

 

How do you calculate Inventory Turnover ratio ?

The formula for calculating Inventory Turnover ratio is

= Cost of goods sold / Average Inventory

Cost of goods sold is the total costs incurred in the production of goods sold. It typically includes raw materials, labour and manufacturing overheads. In some cases, it may also include selling expenses depending upon the type of business.

Average inventory is the average of Inventory balance available at the beginning of the year and that the Inventory balance available at the end of the year.

Thus average inventory = ( Beginning Inventory + Closing Inventory ) / 2

 

Is high Inventory turnover good or bad ?

A high inventory turnover ratio implies that the company is able to sells its goods quickly due to a good demand for their goods in the market. It also implies that the company is managing its stock efficiently. A high inventory turnover is predominantly found in the retail sector.

A high turnover ratio is an indicator of increase in revenue due to the quick turnaround from inventory to sales. This is due to the reduction in holding costs that are associated with inventory.

It also indicates that the company enjoys liquidity of funds as it is able to convert its inventory into sales in a short period of time.

Thus, a high inventory turnover is one of the sign of a company’s overall efficiency.

A high turnover ratio also may pose a risk of running out of inventory due to the speed at which inventory is moving out and being replenished. 

 

What is low inventory turnover ratio ?

A low inventory turnover ratio means the company is not able to sells its goods. It is an indicator of decline in the demand for goods. It is a usual scenario and is mostly seen in manufacturing and heavy industries sector.

 

What does an Inventory turnover ratio of 5 mean ?

An inventory turnover ratio of 5 means that a firm is able to sell and restock its inventory 5 times a year. It can be understood that a company is able to sell and restock its inventory every ( 12 / 5 ) = 2.4 months i..e, 2 and half months in a year.

 

What is a good inventory turnover ratio ?

A ratio between 6 to 10 is considered a good Inventory turnover ratio. It also depends on several factors like, type of product sold, type of industry, general economic and market conditions prevalent and the like.

In case of fast moving consumer goods like household products namely detergents and shampoos, a turnover ratio between 8 to 12 is fairly good. Luxury products may have higher sales values when compared to fast moving consumer goods but will have a low turnover ratio due to the price of the product. Eg: Gold and diamonds. Thus for luxury goods a ratio between 2 to 5 is common.

 

Example :

For the year 2021, Cash Rich Co. has a cost of goods sold of $ 1,000,000, Inventory at the beginning of the year is $ 300,000 and Inventory at the end of the year 2021 is $ 100,000. Calculate the Inventory turnover ratio for the year 2021.

Solution:

The formula for calculating the Inventory Turnover ratio is

= Cost of goods sold / Average Inventory

 

As per the information given in the question we have

Cost of goods sold = $ 1,000,000 ; Beginning Inventory = $ 300,000  ;  Ending Inventory = $ 100,000  ;

Average Inventory = ( Beginning Inventory + Ending Inventory ) / 2

= ( $ 300,000 + $ 100,000 ) / 2

= $ 400,000 / 2 = $ 200,000

 

Thus applying the above values in the formula we have Inventory turnover ratio as

= $ 1,000,000 / $ 200,000

= 5 times or 5x

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