Inventory Turnover Ratio

Inventory Turnover Ratio is an efficiency ratio that measures how well a company manages its stock of goods. The calculation is cost of goods sold divided by average inventory.

What is Inventory Turnover Ratio?


The Inventory Turnover Ratio is the number of times that a business sells and replaces its stock of goods in a given time period.

Inventory turnover is an efficiency ratio calculated by dividing cost of goods sold (COGS) by average inventory, to show how many times inventory has sold in a period.

Cost of goods sold (also called cost of sales) is the expenses associated with generating revenue. In this case, it refers to the cost that the company paid for inventory and other direct costs. cost of goods sold is found on a company’s income statement.
Average inventory is calculated by adding beginning inventory to ending inventory and dividing by two. Another version of this formula will take the daily balance and divide by the number of days, but that is typically in more advanced situations. Inventory accounts are found on the company’s balance sheet.

Companies want a higher inventory turnover ratio as higher turnover rates means reducing storage costs, excess inventory, and holding costs. A lower turnover rate means that items sit in inventory for longer, a sign that there may be a problem with purchasing or merchandising.

As such, this ratio is used to track how efficient a business is at inventory management.


How Do I Calculate Inventory Turnover Ratio?


The inventory turnover formula is cost of goods sold divided by average inventory.


Inventory Turnover Ratio = Cost of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2)

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

The inventory turnover ratio is cost of goods sold divided by average inventory for the period.

The result of the Inventory Turnover Ratio calculation is a number that shows how many times inventory has been sold and replaced in a given time period. If the answer is 2.0, that means the average inventory was sold and repurchased twice.

If you want to run Inventory Turnover for February 2021, you would use the beginning and ending inventory values for February. If you wanted the values for fiscal year 2021, you would use the beginning and ending inventory values for the entire year.


Examples of Inventory Turnover (ITR)


Here are two examples of the Inventory Turnover Ratio.


Company A

Income Statement Accounts

  • Total Revenue: $360,000
  • Cost of Goods Sold: $290,000

Balance Sheet Accounts

  • Beginning Inventory: $180,000
  • Ending Inventory: $200,000

Since we are given Beginning and Ending Inventory, we must first calculate Average Inventory before we use the Inventory Turnover calculation.


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

Average Inventory = ($180,000 + $200,000) / 2

Average Inventory = $380,000 / 2

Average Inventory = $190,000


Great, now let’s use the Inventory Turnover formula.


Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Inventory Turnover Ratio = $290,000 / $190,000

Inventory Turnover Ratio = 1.53x


Over the course of the year, Company A turned over its inventory 1.53 times.


Company B

Income Statement Accounts

  • Total Revenue: $1,000,000
  • Cost of Goods Sold: $850,000

Balance Sheet Accounts

  • Average Inventory: $330,000

Since we are given the inventory average, we can use the shorter version of the formula.


Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Inventory Turnover Ratio = $850,000 / $330,000

Inventory Turnover Ratio = 2.58x


Over the year, Company B sold and replenished its inventory 2.58 times, making it more efficient than Company A.


How is Inventory Turnover Used?


Inventory Turnover is a measure of efficiency, so company managers will use the ratio to understand how they are performing month-over-month, this year compared to prior year, and (for larger companies) how they are doing compared to industry averages.

Higher inventory turnovers mean that companies keep less idle inventory, and the stock they buy is sold quickly. As you can imagine, this is better for cash flow and allows money to be invested in new inventory that can be sold for a profit.

Lower inventory turnovers mean that inventory stays longer and more cash is tied up in large inventory balances. Companies with low turnover ratios should evaluate what the problem could be. For example, are prices too high, selection lacking, or the marketing ineffective.


What is a Good Inventory Turnover Ratio?


A good Inventory Turnover Ratio is between 4 and 6. A good ratio means that you will not run out of products, and you also won’t have a large amount of unsold inventory taking up space and tying up cash.

An Inventory Turnover Ratio of 6 means that a company is restocking its inventory every 2 months. A high ratio shows a better management of cash, but could lead to temporarily having items out of stock. A low ratio means that items are sitting in inventory for too long.

Companies want a higher ratio, as that reduces idle inventory and reduces holding costs. As with other accounting ratios, a “good” or “bad” ratio will depend on the company stage and industry.

Managers can turn to inventory management software and more detailed sales analytics to understand why certain products are selling and other products are sitting in warehouses.


What is a Good Inventory Turnover Ratio?


Inventory Turnover Ratio (ITR) is a great way of understanding the efficiency of a company’s inventory management. The formula is Cost of Goods Sold / Average Inventory, ITR can be calculated for any period of time.

The formula uses COGS instead of Total Revenue because we want to track what you paid for the items (COGS) instead of what income you generated (COGS + your markup). Although, in some cases, it can be useful to also track Total Revenue / Average Inventory.

A low inventory turnover rate means that inventory sits, and could be a sign of weak sales, excess inventory, or poor purchasing decisions. A high turnover rate means that inventory is buying quickly, resulting in higher sales and better cash flow for the business.

All businesses need to manage their cash carefully, so executives, managers, lenders, and investors will look at whether a company has a low ratio or a high ratio. In general, retailers that move inventory faster tend to outperform the competitor.

The ITR can be used by retailers of all sizes to help make decisions like how much inventory to buy, what sizes and SKUs sell best, and how to create more accurate budgets.

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