This lesson will examine the inventory turnover ratio. There will be a brief discussion of the definition and formula. An example of how to use an inventory turnover ratio will be given.
Inventory Turnover Definition & Formula
For any firm that sells physical goods, inventory is one of their largest assets.
Managers must effectively manage inventory through periodic analysis to maintain the financial health and performance of a firm.One tool used to evaluate how inventory is managed is inventory turnover, how fast inventory is sold and has to be replaced during a given period of time. Inventory turnover is expressed as a ratio. So the inventory turnover ratio is the rate obtained from calculating how often a store sells its goods. There are two formulas used to calculate the inventory turnover ratio.
This lesson will only focus on the most common formula:Inventory turnover = cost of goods sold / average inventoryOnce you know where to look for the necessary information, calculating the inventory turnover ratio is easy. Your financial statements will contain all the information you need to perform this calculation. The cost of goods is found on the income statement, while the average inventory is found on the balance sheet. Average inventory is calculated by adding the beginning and ending inventory for a specific period then dividing the number by two.Here is an example of how an inventory ratio would be calculated:Cost of goods sold = $100,000Average inventory = $20,000Inventory turnover = $100,000/ $20,000The Inventory turnover ratio is 5
What the Inventory Turnover Ratio Tells You
Terrence and Tiara are a brother and sister who share a love for T-shirts and decided to open up a store.
The brother and sister work well together because they both perform roles in the company that suits their different personalities. Terrence is gregarious and loves to be out front greeting customers and making sales. Tiara prefers to manage the inventory. The siblings know that for the business to be successful they need to balance both sales and inventory.
Every year Tiara analyzes how well they are managing the inventory by calculating the inventory turnover ratio. Tiara found that for the year 2014 they had an inventory ratio of 5%. The 5% ratio revealed that TNT T-shirts sold completely out of their inventory 5 times during the year and needed to replenish it. When Tiara compared the 2014 ratio to previous year’s ratios, she began to notice a trend and could draw conclusions on how well they were managing their inventory.The inventory turnover ratio for TNT T-shirt’s was 3.7% for 2013, 3.
3% for 2012, and 2.5% for 2011. Over the last 4 years TNT T-shirts has increased its inventory turnover ratio. Tiara knew that because their ratio had increased. Over time they were likely becoming more efficient at managing their inventory. However, because a high and low inventory ratio could mean several things, Tiara decided that she needed more information to understand how well they were doing.
A high inventory turnover ratio is generally a good thing because it means that a retailer is able to rapidly sell their merchandise. On the other hand it could mean that inventory is so low that customer needs are not met and sales are lost.A low inventory turnover ratio usually means that inventory is slow to sell. When inventory takes a long time to sell, it could mean that there is a problem with the product or that too much inventory is on hand. Retailers also incur holding cost for keeping inventory too long. Retailers are then forced to markdown inventory in the hopes of selling it.Whether or not a ratio is high or low depends on the industry.
For instance, inventory that has high profit margins, such as luxury cars, will have a lower inventory turnover ratio then inventory that has smaller profit margins or a short shelf life, such as food.Tiara first needed to know how their inventory ratio compared to similar retailers. She got online and did some research to find out how their inventory turnover ratio compared to similar retailers. She found out that among similar retailers there is an industry average of 6.
3%. Tiara also found out that her closest competitor had a ratio of 5.7%. The inventory turnover ratio for TNT T-shirt’s was lower than its competitors and the industry average.
Tiara knew she needed to evaluate her inventory management strategies to increase her ratio. She decided to markdown all their old inventory and make sure they had a three to four month supply for their best sellers.
Inventory turnover ratio is the rate obtained from calculating how often merchandise is sold out and replaced during a specific period of time.This lesson focused on one formula to calculate the inventory turnover ratio:Inventory turnover = cost of goods sold / average inventoryWhat does the ratio mean?
- A high ratio can be good or it can indicate that inventory is low.
- A low rate can indicate that inventory management is inefficient, that there is a problem with the inventory, or that too much inventory is being ordered.
The inventory turnover ratio needs to be compared to retailers’ past ratios as well as industry average ratios to understand how efficient your inventory management is.