Inventory Turnover Ratio – Meaning, Formula and Interpretation

A company is said to be more efficient when it keeps the least inventory on hand to make the sales it does. The systems of the company must be so efficient that goods are available for sale as and when required and spend the least amount of time waiting in a warehouse. This is because inventory has many costs associated with it. Until earlier it was known as the necessary evil. Not only is capital locked in inventory creating an opportunity cost, there are other costs involved like warehousing, security, insurance, pilferage and so on.

The idea that inventory should be minimized if not eliminated caught the fancy of management gurus from 1980’s onwards. Japanese companies showed how they could produce efficiently at lower costs by implementing Just in Time inventory systems. Many years later, Michael Dell revolutionized the computer industry with his made-to-order business model that enabled him to function with zero inventories and earning almost double the profits that entrenched competitors with deep pockets could manage.

Since inventory is such a make or break item in the financials of a company, there is obviously an interest amongst analysts and investors who want to have a close watch on its performance. Hence, the inventory turnover ratio is amongst their favorites. This article explains the inventory turnover ratio in detail.

The Formula

Inventory Turnover Ratio = Cost Of Goods Sold / Average Inventory^*

• Average Inventory = (Beginning Inventory + Ending Inventory) / 2

• Note that instead of Sales, Cost of Goods Sold is used to calculate this specific turnover ratio. This is because inventories are stored at cost price.

How to Apply it ?

Like all ratios, inventory turnover ratio also needs the same context for the numbers to become meaningful. It needs to be compared with the performance of others. Usually the comparison is done between:

• The company’s own inventory turnover ratio for previous years.

• The inventory turnover ratio of other companies in the same or different industry. Different industries are usually considered in the calculation of inventory turnover ratio. This is because the best practices can usually be applied regardless of the industry. Dell’s made to order business model has been replicated countless times in different industries.

Interpretation

Caution must be exercised by the analysts in drawing conclusions based on the inventory turnover ratio. Sometimes companies buy large amounts of inventories to beat the forthcoming price hikes. This may show up as an increasing inventory turnover ratio but may not be a bad signal in reality.

Also analysts must be wary of change in inventory policies before calculating and interpreting this ratio.