Inventory Turnover Ratio

Inventory activity ratios provide a measure of both the quality and the liquidity of the inventory on hand. Both quality and liquidity of inventory give an indication of the salability of the inventory.

The inventory turnover ratio indicates how many times during the year the company sells its average level of inventory.

The annual average inventory may be calculated as simply the average of the year’s beginning inventory and ending inventory. However, if inventory fluctuates seasonally, a more useful average inventory figure would result from averaging actual quarterly beginning and ending or even monthly beginning and ending inventory balances. The quarterly or monthly averages can then be averaged to develop the average for the year.

In whatever way the average inventory balance is calculated, it is important for the numerator and the denominator of the Inventory Turnover Ratio to represent the same time period, and it is important that the cost of sales figure be multiplied by whatever number is needed to annualize it. For example, if the cost of sales figure represents the cost for one quarter, multiply it by 4 to annualize it. The average inventory figure used should be the average during the same period as is covered by the cost of sales figure before annualizing it. If the cost of sales figure used is for one quarter, the average inventory used should be the average inventory for the same quarter.

As with the accounts receivable activity ratios, the inventory activity ratios should be evaluated by comparing them with industry averages and with previous periods’ amounts for the same company.

An increase in cost of goods sold without an equivalent increase in inventory causes the inventory turnover ratio to increase and means inventory is turning over more rapidly than previously. If a company has a high inventory turnover ratio, it may mean the company is using good inventory management and is not holding excessive amounts of inventories that may be obsolete, unmarketable goods. However, it can also mean that the company is not holding enough inventory and may be losing sales because prospective customers may be unable to make purchases due to out-of-stock items.

On the other hand, an increase in inventory without an equivalent increase in cost of goods sold causes the inventory turnover ratio to decrease and means the inventory is turning over more slowly than previously. A low inventory turnover ratio may mean that the company is holding too much inventory, and although the risk of lost sales due to stock-outs is lower when inventory is higher, the company may be losing the return that it could earn by investing in more productive assets. In addition, the company may be carrying on the books some obsolete inventory that cannot be sold and that needs to be written down or written off. However, a low inventory turnover ratio may also be the result of building up inventory for anticipated sales increases or anticipated difficulty in obtaining inventory due to possible future work stoppages.

Further analysis is needed in order to draw a conclusion from either an increase or a decrease in a company’s inventory turnover ratio.