What is ‘Inventory Turnover’
Inventory turnover is a ratio showing how many times a company’s inventory is sold and replaced over a period of time. The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand. It is calculated as sales divided by average inventory.
BREAKING DOWN ‘Inventory Turnover’
Inventory turnover measures how fast a company is selling inventory and is generally compared against industry averages. A low turnover implies weak sales and, therefore, excess inventory. A high ratio implies either strong sales and/or large discounts.
The speed with which a company can sell inventory is a critical measure of business performance. It is also one component of the calculation for return on assets (ROA); the other component is profitability. The return a company makes on its assets is a function of how fast it sells inventory at a profit. As such, high turnover means nothing unless the company is making a profit on each sale.
Inventory Turnover Example
Inventory turnover is calculated as sales divided by average inventory. Average inventory is calculated as: (beginning inventory + ending inventory)/2. Using average inventory accounts for any seasonality effects on the ratio. Inventory turnover is also calculated using the cost of goods sold (COGS), which is the total cost of inventory. Analysts divide COGS by average inventory instead of sales for greater accuracy in the calculation of inventory turnover. This is because sales include a markup over cost. Dividing sales by average inventory inflates inventory turnover.
Approach 1: Sales Divided By Average Inventory
As an example, assume company A has $1 million in sales. The COGS is only $250,000. The average inventory is $25,000. Using the first equation, the company has inventory turnover of $1 million divided by $25,000, or 40. Translate this into days by dividing 365 by inventory days. The answer is 9.125 days. This means under the first approach, inventory turns 40 times a year, and is on hand approximately nine days.
Approach 2: COGS Divided By Average Inventory
Using the second approach, inventory turnover is calculated as the cost of goods sold divided by average inventory, which in this example is $250,000 divided by $25,000, or 10. The number of inventory days is calculated by dividing 365 by 10, which is 36.5. Using the second approach, inventory turns over 10 times a year and is on hand for approximately 36 days.
The second approach gives a more accurate measure, as it does not include a markup. Only compare inventory turnover that uses the same approach for an apples-to-apples comparison.