Inventory turnover ratio is an important metric used by investors and analysts in the their analysis of a firms financial performance. The ratio shows how many times stock is sold during a financial year by a firm. Of course, inventory turnover ratio can be also calculated on different intervals, for example on a monthly or a quarterly basis.
Inventory Turnover Ratio Formula
The formula that is used to calculate the Inventory Turnover Ratio is quite simple. The formula is:
Cost of Sales / Average Inventory for the Year
Where Average Inventory for the year is:
(Opening Inventory + Closing Inventory) / 2
If the stock levels do not drastically change year one year, it’s also possible not to use the average inventory levels and just use the final closing stock balance.
In addition, it’s also possible to use specific costs that are included in the stock line item in order to further refine the ratio and make it more accurate. As an example, certain overhead costs such as labor can be excluded since they are allocated to stock as needed while raw materials for example are actually purchased by the company.
The table 1 below summarises the information we need in order to calculate the inventory turnover ratio for two hypothetical companies, Company A and Company B.
|Cost of Goods Sold|
|Inventory Turnover Ratio|
Company A is smaller than Company B both in terms of year end stock levels but also in terms of cost of sales. However, the Inventory Turnover Ratio is lower for Company B (Cost of Goods Sold / Average Inventory).
Inventory Turnover Ratio Analysis
As explained in the introduction above, the inventory turnover ratio shows how many times stock is sold or replaced during the year.
Therefore, it’s reasonable to assume that the higher the inventory turnover ratio the better. The reason for this is that a higher ratio is correlated to higher sales and also lower (always comparatively) lower year end stock levels.
A low inventory stock level is usually connected to the following issues:
- The sales made during the year might have been low;
- The stock level either brought forward or purchased during the year might have been high (or both of these might have happened);
- High stock levels at the year end which can create additional costs since inventory can become obsolete; and
- High stock levels also cost since the company will need to spend for storage, handling and other associated costs.
At the same time, having unusually high inventory turnover ratio can be also associated with a couple of negative points. For example, high stock turnover can mean that the company might be having difficulties in keeping a certain level of stock level at all times which leaves it open to price fluctuations of its stock.
It is worth noting that each company operates in a different industry. For example, a company that builds houses will have a higher year end stock amount compared to a company that sells fresh meat.
As a result of that, the first company will have a lower inventory turnover ratio compared to the second company. It’s therefore advisable to benchmark each company against other comparable companies.
Inventory Turnover Ratio Calculator
In order to use the online calculator below, just fill in the cost of goods sold (or as it’s also called cost of sales) and the average inventory figure.