Inventory is the collection of goods a company has in its stock. This includes raw materials, unfinished goods, and goods that are ready to be sold.
Generally, inventory refers to the finished goods. This can also include the raw materials required for the production of finished goods called work in progress.
Inventory turnover is the measure of how many times a company sells and replaces its goods in a given frame of time. Inventory turnover gives an idea of how well a company is managing its cost and how effective the company is at selling its goods.
A high inventory turnover indicates that the company is selling their goods at a high rate and the demand for their product is high. Meanwhile, a low inventory turnover suggests that the sales of the goods are low and the demand for the product is falling.
Inventory turnover gives an insight into whether a company is managing its stock properly. It also shows whether a company’s sales and purchasing departments are operating synchronously.
Calculation of inventory turnover formula
The inventory turnover formula is also known as the inventory turnover ratio or the stock turnover ratio. The inventory turnover ratio is an efficiency ratio. It shows how successfully a company is managing its inventory. It details how much inventory is sold within a period of time, commonly a year.
To calculate the inventory turnover ratio cost of goods sold is divided by the average inventory for the same period.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Here average inventory is used because companies may have higher or lower levels of inventory at different times of the year.
For example, some companies would likely have a higher inventory before a certain holiday period and lower inventory levels after the holiday.
Average inventory is usually calculated by adding the inventory at the start and inventory at the end of a given period of time and dividing this by two.
The cost of goods sold is the production cost of goods and services that the company produces. It can include the cost of raw materials and labor costs required for making the goods. Other factory overheads can also be included. The cost of goods is reported on the income statement.
Inventory turnover will be more refined if the labor cost and other overheads are removed from the cost of goods. This will give more attention to the cost of materials.
The time period in calculating inventory turnover ratio is usually taken as a year. Dividing the year into different quarters and calculating the average inventory of the 4 quarters.
Days in inventory
The days in inventory (DII) is a financial measure of a company’s performance. It gives an idea for the investors about how long it will take the company to convert the inventory into sales.
It is always preferable if the DII is low because the goods produced are being cleared from the company’s stock at a high rate. It is important to note that the average DI changes from one industry to another.
DII is also referred to as day’s inventory outstanding (DIO), day’s sales of inventory (DSI) or simply day’s inventory.
It is calculated as:
DII=inventory cost of sales*365 days
DII=365 days inventory turnover ratio
The DII is the first stage in the cash conversion cycle, which represents the conversion of raw materials into cash. The DII is another measure to check the effectiveness of inventory management.
Calculating the number of days a company holds on to an inventory before it is sold, the length of time the company’s cash is tied up in inventory can be calculated.
The DII varies greatly with industry. It is important to compare DII of one company to another of the same industry.
For example, the companies that sell food items or products that expire quickly have low DII while those companies which sell slow-moving products or non-perishable products tend to have a high DII.
Both these metrics, days in inventory and inventory turnover ratio, helps an investor in making investment decisions. It informs the investor of how effective a company is in managing its inventory compared with its competitors.
Studies suggest that stocks with higher inventory ratios tend to outperform industry averages. Low inventory ratio may suggest overstocking, product deficiencies or poor management of inventory. These are signs which do not bode well for a company’s overall performance.
There are also some exceptional cases where low inventory ratio is preferred. For example, if the inventory is increased in anticipation of a market shortage or a rapid price increase. If inventory is selling slowly, then a high inventory is not advantageous.
On the other hand, a shortage of inventory can lead to a higher turnover ratio, though the company may experience a loss in sales. Therefore it is necessary to find a balance between inventory levels and market demand.
ABC is a computer manufacturing company. The opening inventory is $30000 and the ending inventory is $35000. The cost of goods manufactured is $250000. To calculate the inventory turnover ratio:
Cost of goods sold= $30000 + $250000-$35000= $245000
Average inventory= (Opening inventory+ closing inventory) ÷2
= ($30000 + $35000) ÷ 2 = $32500
Inventory turnover ratio= cost of goods sold ÷ average inventory= $245000 ÷ $32500= 7.53
To calculate the days in inventory
DII= 365 days ÷ inventory turnover ratio= 365 ÷ 7.53= 48.47
XYZ is a trading company. The following data is provided for the year 2017:
Inventory turnover ratio= 10 times
Opening inventory at cost= $20,000
Closing inventory at cost= $40,000
To calculate the cost of goods sold for the year 2017:
Inventory turnover ratio= Cost of goods sold ÷ average inventory
Average inventory = ($20000+ $40000) ÷ 2= $30000
Therefore, cost of goods sold= 10 * 30000= $300000
Days in inventory can also be determined:
DII= 365 days ÷ inventory turnover ratio= 365 ÷ 10= 36.5
What is a good inventory turnover ratio?
The higher the inventory turnover ratio the better seems to be the easy answer. Companies that have a high turnover ratio have excellent sales. A higher inventory turnover ratio means that fewer inventories are required to support sales, therefore less warehouse space and capital is required.
To idealize the inventory turnover companies should make certain that the products that are in demand are shipped and delivered to the customers in a short span of time.
Inventory turnover ratio is limited by certain factors such as replenishment frequency, the reliability of supply and sales dynamics; it can also be reduced because of the poor quality of the inventory management software system.
There are a few methods that companies use to improve the inventory turnover ratio:
- To get rid of excess or obsolete inventory their prices are reduced in order to free up cash.
- Companies work closely with suppliers so as to deliver purchases frequently.
- They create methods to forecast sales demands.
- Limit bulk orders to big sellers to prevent excess inventory on the shelf.
The turnover ratio varies by industry and it is an individual indicator for each company. The industry indicator is not a measure to follow.
By using proper analysis of data the best inventory turnover ratio of an industry can be improved.
Calculating inventory turnover ratio might sound like a technical thing to do. However, when the business grows, it becomes important to stay on top of these numbers.
We can improve only those things that we measure.
It is recommended to use a good inventory management software to track your workflow.