What is Inventory Turnover?
Inventory turnover is a ratio that shows the number of times that a company can sell through its inventory in a given period of time.
Companies that sell physical products keep track of the value of the products that they have in stores and warehouses: their inventory. Inventory turnover is the number of times a company is able to sell through all of the products it has in inventory over a specific time period. Inventory turnover is typically expressed as a ratio. To simplify the calculation, inventory turnover uses the value of products sold compared to the value of products in stock.
Consider a company that sells cell phones. On average, the company has an inventory of cell phones worth $1 million spread between its stores and warehouses. If the company earns $5 million in sales each year, its inventory turnover is five times per year ($5M/$1M).
Inventory turnover is like measuring speed during a race...
When you look at a runner or a racecar driver, you want to look at how fast they can move around a track, so you ask how much distance they can travel in a period of time. You might measure their speed in miles per hour or meters per second. With businesses, it's useful to know how quickly they can sell their inventories, so you measure their inventory turnover.
Inventory turnover is a measure of how quickly a company sells through its inventory. Companies with higher inventory turnover sell through their stock more frequently than companies with low inventory turnover.
Inventory turnover is expressed as a ratio, indicating the number of times a company sells its inventory during a period, usually a year.
Higher inventory turnover ratios are a good thing for businesses because they indicate faster sales and lower inventory levels, which reduces inventory costs.
There are two methods that you can use to calculate inventory turnover for a period.
The first is:
(Beginning Inventory - Ending Inventory) / 2 = Average Inventory
Sales / Average Inventory = Inventory Turnover
The second formula is:
Cost of Goods Sold / Average Inventory
Some analysts use a company's cost of goods sold instead of sales when calculating because they feel it is more accurate. Sales prices include a markup over the cost of the inventory, which can inflate the resulting inventory turnover ratio.
Inventory turnover measures a company's ability to sell through all of its inventory. The higher the turnover ratio, the less time it takes for the company sells through its inventory.
Typically, a high inventory ratio is a good thing for companies. High turnover ratios can indicate strong sales numbers or a company that manages its inventory efficiently. On the other hand, a company that doesn't carry sufficient stock might have a high turnover ratio while leaving money on the table in the form of lost sales.
Low inventory ratios usually indicate a company that is failing to sell its goods or with too much inventory. However, low inventory turnover can be a good thing if prices are expected to rise or if a shortage is expected because it may indicate that a retailer has sufficient inventory to capitalize on rising prices.
Seasonal businesses will need to look at the inventory turnover with an eye toward seasonality. A store specializing in holiday decorations might have a higher turnover near Christmas, Halloween, or the Fourth of July because of increased sales. Similarly, they may have a lower turnover in the months leading up to the holidays as they stock up on additional inventory to prepare for the rush.
Investors care about inventory turnover because it is an easy indicator of the strength of a business.
Companies that carry inventory make a lot of their money by selling that inventory. The more products that a retailer sells, the higher its revenues tend to be. Higher inventory ratios usually correspond to higher sales numbers, so looking at the inventory turnover ratio gives investors an easy way to compare businesses in the same sector in a way that looking at raw sales numbers can't. Two retailers of different sizes will have vastly different sales numbers, but their turnover ratios can show how many sales they make relative to the inventory they carry.
Investors also care about inventory turnover because it can show the efficiency of a business's supply chain. Holding inventory brings associated costs. First, the company may own or rent a warehouse to store its goods. Depending on the type of inventory, spoilage or shrinkage (theft) can also be a problem, which increases inventory costs.
Higher inventory turnover ratios can mean lower inventory levels overall, meaning the business incurs fewer inventory costs, freeing up cash for more productive uses.
Beyond the fact that lower turnover ratios can indicate higher inventory costs, businesses care about their inventory turnover ratios because it can help the business estimate its ability to sell goods for the cash it needs to cover liabilities. Higher ratios can indicate higher levels of liquidity because the company will sell its products more quickly.
For example, a business with an inventory turnover ratio of 6 can assume it will sell its current inventory within two months (6 times per year equals once every 2 months). If the company needs to forecast its ability to pay future bills, knowing how quickly it can sell its inventory is important.
The ability to predict how long it will take to sell current inventory is important for businesses that handle products that eventually become obsolete. It can help them figure out how much product to stock based on the release date of the next product that will render current stock obsolete.
Dead stock refers to goods or merchandise that were not sold to consumers. When a company removes unsold goods from its stores, they become dead stock.
Dead stock does not always remain dead stock. The retailer may make it available for sale at a later date or find another way to liquidate it to recoup some of the cost.
Goods can become dead stock because they become obsolete or when trends change (for example, many retailers likely failed to sell all of their stock of fidget spinners before the fad died). Halloween candy becomes dead stock on November 1st because people no longer need the candy to hand out.
Companies that sell through their inventory more frequently or that carry less inventory likely have less dead stock than other businesses, which translates to lower costs.
Open-to-Buy (OTB) is an inventory management system for retailers. Businesses use open-to-buy to determine how much inventory they'll need to cover customer demands while having positive cash flow.
Businesses use the following formula to calculate the Open-to-Buy amount.
Planned sales + planned markdowns + planned ending inventory - planned beginning inventory = Open-to-Buy.
The Open-to-Buy amount is the amount of money that the retailer should spend on goods in the coming period. Because retailers have to buy inventory regularly, they usually calculate Open-to-Buy every month.
Many retailers will use the OTB formula for each part of its business. A grocer might run OTB calculations individually for the meat department, produce, and prepared goods sections of the store, so it knows what to spend in each area.
Inventory turnover ratio measures how quickly a business can sell through its inventory. Typically, the ratio is measured in terms of turnovers per year.
Day Sales of Inventory (DSI) is a related measure that looks at how long it takes for a company to turn inventory into sales. The formula for DSI is:
Cost of Goods Sold / Inventory * 365 = DSI
This can also be expressed as:
365 / Inventory Turnover Ratio = DSI
For example, a company with a DSI of 45 can assume that it will sell its inventory 45 days after purchasing it.
One of the greatest limitations of using the inventory turnover ratio is that it looks purely at the cash value of inventory rather than looking at the individual goods a retailer has in its stock. This means that it provides a high-level view of a business's inventory management but cannot replace careful analysis of each product a retailer sells. A company with a stellar turnover ratio may have one product that sells incredibly well and another that languishes until most of the stock becomes dead.
Another limitation of inventory turnover is that it's only useful for comparing businesses in similar industries. While gas stations and warehouse stores both sell goods and carry inventory, successful gas stations and warehouse stores will have very different turnover ratios from each other.
Even within the same industry, inventory turnover is imperfect if the companies involved use different inventory valuation methods. A business that uses Last-In, First-Out (LIFO) valuation will produce different turnover ratios than businesses that use First-In, First-Out (FIFO) valuation, even if their inventory numbers and sales are similar. This effect can be especially exaggerated if the market value of the goods the companies sell changes regularly.
The inventory turnover ratio also does a poor job of accounting for discounts offered to consumers. If a retailer uses the Cost of Goods Sold formula to determine its turnover ratio, it can manipulate the result by providing huge discounts to customers, which increases turnover ratio without increasing revenue as much as expected.
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