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What Is the Inventory Turnover Ratio?

Chime Team • July 11, 2024

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Inventory Turnover Ratio

The inventory turnover ratio is a key financial metric that measures the efficiency of a company in managing and selling its inventory within a certain period. It indicates how often a company has sold and replaced its inventory over a fiscal year.¹

This ratio is critical for businesses, investors, and financial analysts as it provides insight into the company’s operational efficiency, product demand, and how well it manages its stock levels.

Whether an inventory turnover ratio is good or bad depends on the industry’s norms and benchmarks. A higher ratio suggests that a company effectively manages its inventory and generates sales. On the other hand, a lower ratio might indicate excess stock, sluggish sales, wasted space, or potentially obsolete inventory. With that level of financial literacy, individuals can make more informed decisions about investing in or managing a business.¹

The inventory turnover ratio is particularly important in industries where products become obsolete quickly, like technology and fashion. Companies in these sectors strive for higher inventory turnover ratios to minimize the risk of being stuck with unsold and outdated products.

For instance, a tech company with a high inventory turnover ratio is likely to keep up with fast-paced innovations, ensuring they are not left with outdated tech.

How to calculate inventory turnover ratio

To calculate the inventory turnover ratio, you divide the cost of goods sold (COGS) by the average inventory on the balance sheet for the period.¹ The COGS measures the direct cost of producing any goods and services, whether it’s materials or labor. The average inventory refers to the mean value of inventory during that period of time.¹

For example, if a company has a COGS of $100,000 and an average inventory of $25,000, its inventory turnover ratio would be 4. This means the company sells and replaces its inventory four times a year.

In personal finance, the inventory turnover ratio of a company can be valuable for investors looking to assess a company’s operational efficiency before making investment decisions.

A company that efficiently manages its inventory likely has good management practices in place, which can be a positive indicator for the future of the business.

While the inventory turnover ratio is a valuable metric for assessing stock management efficiency, it doesn’t account for everything. Industries differ by default regarding inventory management and ideal ratios, making cross-industry comparisons less accurate.

Seasonal fluctuations can also distort the ratio, as peak season sales may impact the overall figure. Cost fluctuations in production, raw material prices, and currency exchange rates can affect the ratio’s accuracy over time.

A high turnover can also be misleading if it doesn’t account for costs associated with low inventory or lead times. This can result in “stockouts,” a situation where a business runs out of a particular product, causing a loss of customer loyalty.

How to approach inventory turnover

Efficient inventory turnover is also linked to other financial concepts like cash flow and profit margins. Managing inventory effectively can lead to better cash flow, as funds are not tied up in unsold stock. It can potentially increase profit margins due to reduced holding costs and less risk of markdowns or obsolete stock.

To help improve their ratio, businesses may invest in automated software to help track stock and sales, reducing risk and maintaining capital. Working with local vendors and manufacturers can also help improve lead times.

Businesses can also find more affordable distributors, order small quantities more frequently, focus on top-selling products, and forecast sales demands, ordering only what is expected to leave the shelf.

The inventory turnover ratio is a vital metric that can shed light on a company’s efficiency in managing and selling its inventory. It is an essential tool for businesses looking to optimize their operations, and investors making decisions about where to allocate their resources.

By understanding and applying this concept, people can gain deeper insights into a company’s operational performance and make more informed financial decisions.

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1 Information from Corporate Finance Institute’s “Inventory Turnover Ratio” as of June 28, 2024: https://corporatefinanceinstitute.com/resources/accounting/inventory-turnover-ratio/

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