What is Inventory Turnover Ratio
Inventory turnover ratio is a measures of how many times a company replenished (or turnover) their inventory in a year. The inventory turnover ratio indicates the liquidity of inventory by measuring the number of time that the inventory is sold during a year.
The inventory turnover ratio is calculated as cost of goods sold divided by average inventory (during a year), as the following inventory turnover ratio formula:
- Inventory turnover ratio = Cost of goods sold ÷ Average inventory
The formula indicates how many times the inventory turnover (is sold) in a single year, and also indicates how long is an item in inventory.
High inventory turnover ratio (low average days in inventory) indicates the business has minimal funds stuck in inventory. However, minimizing the funds tied up in inventory is efficient, but too high and inventory turnover might lead the business into losing sales opportunities because of inventory shortages problem.
In contrast, with a low inventory turnover ratio, the business may be holding obsolete goods that are not worth their actual value.
Key Points
- Inventory turnover ratio is an inventory management ratio that reflect how many times a company replenisheds (or turnover) their inventory during a year (or an account period).
- High inventory turnover ratio (low average days in inventory) indicates the business has minimal funds stuck in inventory. In contrast, with a low inventory turnover ratio the business may holding obsolete goods
- However, too high and inventory turnover might lead the business into losing sales opportunities because of inventory shortages issue.
- Inventory turnover ratio can be converted into the number of days’ sales in inventory, which indicates the average number of days inventory is held.
Inventory Turnover Ratio Calculation
Inventory turnover ratio can be calculated by dividing the cost of goods sold by average inventroy (during a year). Where the Average Inventory is calculated by dividing the sum of beginning and ending inventory by 2.
Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory
For example, the Feriors company’s balance sheet shows the cost of goods sold of $12 million, the inventory at the beginning of period of $3 million, and the inventory at the end of period of $5 (average inventory = $4)
Inventory Turnover Ratio = $12 ÷ $4
The feriors’ inventory turnover is 3 times, which means the company’s inventory sold 3 times during a year (or a period).
Days Sales in Inventory
The inventory turnover ratio can be divided into 365 days to converted into the number of days’ sales in inventory. Days’s sales in inventory is indicates the average number of days inventory is held.
Days sales in inventory can be calculated by dividing 365 by the inventory turnover as the following formula:
Days sales in inventory = 365 ÷ Inventory turnover ratio
From the example above, days sales in inventory = 365 ÷ 3
The Feriors’ days sales in inventory is 122 days, which means the company can sold their goods every 122 days (in average).
Frequently Asked Questions
Inventory turnover ratio is an inventory management ratio that reflects how many times a company replenished (or sold) their inventory during a year.
The inventory turnover ratio can be calculated by the following formula: Inventory turnover ratio = Cost of goods sold ÷ Averageinventory
The high inventory turnover ratio is good, It indicates the business has minimal funds stuck in inventory.
High inventory turnover ratio is good but too high and inventory turnover might lead the business into inventory shortages.
