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The faster inventory turnover occurs, the more efficiently a business operates while experiencing a higher return on its equity and other assets. An inventory turnover ratio, also known as inventory turns, provides insight into the efficiency of a company, both absolute and relative when converting its cash into sales and profits.
For example, if two companies each have $20 million in inventory, the one sells all of it every 30 days has better cash flow and less risk than the one that takes 60 days to do the same.
The formula is a straightforward method for determining how often a company turns over its inventory over a specified period of time.
Inventory Turnover = Cost of Goods Sold / Average Inventory for the Period
To get an annual number, start with the total cost of goods sold for the fiscal year, then divide that by the average inventory for the same time period. The cost of goods sold, sometimes called cost of sales or cost of revenue, typically is found beneath the revenue figure on a company's income statement. To get the average inventory balance, add the current inventory balance to the previous period's inventory balance and divide by two.
Some analysts use total annual sales instead of the cost of goods sold. This includes a company's markup and can lead to a different result. When comparing two companies, be sure use ratios calculated the same way to avoid inconsistent or faulty results.
The time it takes a company to sell its inventory varies greatly by industry. Retail stores and grocery chains typically have a much higher inventory turn rate since they sell lower-cost products that spoil quickly, requiring far greater managerial diligence.
Companies that manufacture heavy machinery, such as airplanes, will have a much lower turnover rate since each product may sell for millions of dollars and take extended periods of time to produce and sell. Hardware companies may turn their inventory three or four times a year, while department stores may turn their inventory six or seven times per year.
Coca-Cola's income statement from 2017 showed the cost of goods sold was $13.256 million, and its average inventory value between 2016 and 2017 was $2.665 million. Dividing 13.256 million by 2.665 million equals 4.974, Coca-Cola's total number of inventory turns for that year. To understand how well Coca-Cola is doing, you would compare this ratio to others in the same industry.
Upon researching, you might find that the average inventory turns for competitors was 8.4 annually, meaning they're selling the product more quickly than Coca-Cola throughout the year. The reason typically involves several different factors, making it important to read a company's financial statements and accompanying disclosure notes.
When analyzing a balance sheet, also look at the percentage of current assets inventory represents. Companies with a lot of assets tied up in inventory need faster turnover.
Although Coca-Cola's inventory turn rate was lower, you might find other metrics showing it still was financially stronger than the other averages for its industry. With such strong economics, it's not likely the company's inventory has an issue with losing value. It's useful to also examine how the inventory turnover calculation changes for a company over a period of many years.
Take inventory analysis a step further by using the inventory turn rate to calculate the number of days it takes for a business to clear its inventory, known as the days' sales of inventory ratio. Using Coca-Cola as an example again, divide 365 (the number of days in a year) by the company's inventory turn ratio, which was 4.974. The answer—73.38—represents the average number of days it took Coca-Cola to sell its inventory.
While the inventory turnover ratio shows how well Coca-Cola turns its inventory of beverages and other products into sales during a given year, the days' sales ratio translates it into a daily view of the company's efficiency.
