What is ‘Inventory Turnover’
Inventory turnover is a ratio showing how many times a company has sold and replaced inventory during a period. The company can then divide the days in the period 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 sells inventory and analysts compare it to industry averages. Low turnover implies weak sales and, excess inventory. A high ratio implies either strong sales or large discounts.
The speed with which a company can sell inventory is a critical measure of business performance. It is also one component in the calculation of return on assets — 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. High turnover means nothing unless the company is making a profit on each sale.
Inventory Turnover Example
Companies calculate inventory turnover as sales divided by average inventory. One can calculate average inventory 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, which is the total cost of inventory. Analysts divide COGS by average inventory instead of sales for greater accuracy in the inventory turnover calculation 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 and $250,000 in COGS. The average inventory is $25,000. Using the first equation, the company has an inventory turnover of $1 million divided by $25,000 in average inventory, which equals 40 turns per year. Translate this into days by dividing 365 by inventory turns. 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, which equals 10. You can then calculate the number of inventory days 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 because it does not include markup. Only compare inventory turnover that uses the same approach for an apples-to-apples comparison.