The inventory turnover ratio describes the relationship between the inventory a company holds, and the sales of the inventory (or the ‘turning over’ of the inventory), within a given time period. The formula which denotes this is as follows:
Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory
There are a few aspects of the ratio and its application which need to be considered. It’s better to use the Cost of Goods Sold for the numerator of the equation, rather than actual sales, as sale prices can fluctuate and do not represent how much the company actually spent to manufacture or acquire the goods.
Likewise, it’s more accurate to use the average inventory for the denominator, rather than the actual value of the end inventory for the period, as this would not take into account the value of the inventory first sold at the beginning of the period, and also does not account for any seasonal changes which may affect inventory. The average inventory is calculated by adding the values of the beginning inventory and end inventory and dividing by 2.
Interpreting the turnover ratio
A large inventory turnover ratio is more often desired, as this implies there is a higher rate of sales in relation to the inventory remaining in stock. This not only means the company is ‘moving’ their stock efficiently, but is also beneficial as there are holding costs associated with remaining stock.
Likewise, if the value of the remaining stock decreases then the company is not put in potential jeopardy. However, if the inventory turnover ratio is too large then issues could arise, such as the inventory being sold running out before more stock is ordered. The result of this could equate to lost sales and a tainted reputation. It’s also important to compare the turnover ratio to the industry average, to make sure the ratio is interpreted in the right context.
A subsequent analysis to the inventory turnover ratio (which can be done to provide more information on the financial health of the company) is to calculate the Days Sales Inventory.
Day Sales Inventory
The following equation denotes how to do this:
Days Sales Inventory = (Average Inventory ÷ Cost of Goods Sold) x 365
Day sales inventory (DSI) gives an indication about the timeframe in which a company can sell their entire inventory. To understand what the calculated DSI means for the company, it is vital to compare it to equivalent companies, as the DSI can change significantly between different industries. For example, a supermarket or store that sells perishable goods with a short shelf-life should have a relatively low DSI. Meanwhile a company which sells big-ticket non-perishable products may have a much larger DSI.
When we say that the inventory turnover ratio – and more specifically the DSI – are good indicators of a company’s financial position, it is meant that they represent the assets the company has which can quickly be turned into cash.
This is especially important for investors with a concern for their investment, or if the company needs to raise debt. Any assets or inventory the company owns which cannot be sold (in a timely manner) are essentially worthless, and therefore equate to lost investments to the investor, and won’t inspire confidence with banks either.
In conclusion, comparison of a company’s Inventory Turnover Ratio and DSI with similar benchmark values is required to properly understand how a company is doing. Improving either of these ratios can be achieved by focussing on balancing the inventory bought and stored, with the inventory being sold before devaluation, deterioration, or expiration of stock occurs.
Here is how Unleashed helps with keeping on top of the stock turn KPI.