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    Inventory Turnover Ratio

     

    Inventory turnover ratio shows how quickly company’s inventory is changing compared to its sales or cost of goods sold. This ratio shows how effectively inventory is managed in company’s production/distribution process.

     

    Inventory turnover ratio formula

      

    Inventory turnover = Sales / Inventory


    Inventory turnover = Cost of sales (COGS) / Inventory


    Both sales and COGS calculation versions are used in practice but more accurate is cost of sales version, because this ratio should reflect effectiveness of inventory usage in activity. If different companies will sell their products on different profit margins, then comparison with sales won’t show real effectiveness. (Simple example: company A makes 10 products per year and at cost of sales for one product $5 when sale price $10; company B also makes 10 products per year and cost of sales for one product is $5 but sale price $5. If both companies will hold 5 products as inventory, they both will manage inventory in equal quality, but inventory turnover ratio will be equal only if will compared to COGS but not to sales).

    Other important factor is seasonality. If business is dependable on seasons, inventory used for calculation should be annual average. The best way would be to have an average inventory for last four financial quarters.   

     

    Inventory turnover ratio usually is compared to the same ratio of similar companies. If this ratio will be used to compare with companies of others sectors, it will be meaningless because every industry has some business specialties and different turnover ratio is normal. 

     

    Normally the higher inventory turnover ratio is the better because it shows that inventory is in better management (less working capital is needed, which means you save some investments in capital); however, if inventory is very low and company has financial problems, it may be another indicator that problems are very serious. 

     

     

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