Inventory turnover is a way to measure the rate at which inventory is consumed during a reporting period. When inventory turnover refers to goods for sale, it is often expressed as an inventory turnover ratio. Inventory turnover can, however, also refer to the supplies a company uses to create its goods.
Examples of inventory turnover
The standard way to calculate the inventory turnover ratio is:
Cost of Goods Sold / Value of Inventory
Another way to calculate it is:
Value of Sales / Value of Inventory
The first method tends to be preferred, especially by analysts, because it tends to be a better reflection of the true cost of the inventory. The sales price, by contrast, will include a markup.
In either case, the value of the inventory will be determined by adding the value of the current inventory to the value of the inventory at the last check and dividing the result by the number of reporting periods this covers.
Since inventory turnover is usually calculated every reporting period, the standard calculation is : (Current Inventory + Previous Inventory) / 2.
Whatever calculation is used, the end result will be the number of times in the reporting period that inventory is sold or used.
Inventory turnover vs day sales of inventory (DSI)
Inventory turnover measures how long it takes for inventory to be consumed (sold or used). Day sales of inventory is a measure of how long it takes a company to convert its inventory of finished goods into sales.
The formula for calculating the DSI ratio is:
(Value of Inventory / Cost of Goods Sold) * Number of days in the year
Most of the time, the number of days in the year will be 365. It is, however, important to be able to adjust for leap years with 366 days.
The end result of this calculation will be the average number of days it takes a company to sell an item of stock.
In accounting, there are three main ways to determine inventory value. These are:
- First-In, First-Out (FIFO)
- Last-In, First-Out (LIFO)
- Weighted Average Cost
There is also the Specific Identification Method. This is, however, very niche. It’s only really suitable for businesses with a very small number of high-value assets.
If you are calculating your inventory turnover ratio over a whole fiscal year, then it generally doesn’t matter which inventory valuation method you use. It is, however, important that you’re consistent in your methodology.
If, however, you’re calculating your inventory turnover ratio over a shorter period, it’s generally best to use the weighted average cost. Using the average value will help minimise the influence of any cyclical fluctuations.
These apply, to some extent, in most business sectors, not just the obvious ones (such as retail).
The importance of inventory ratios
In general, analysts want to see high inventory turnover ratios and low DSI ratios. These are both potential indicators of robust inventory management.
There are, however, a couple of potential caveats.
Firstly, turnover rates are heavily dependent on the type of product being sold. This means that there can be wide variations in them, even within the same business sector. For example, a luxury jewellery shop and a fast-fashion shop are both in the retail sector. They will, however, usually have massively different turnover rates.
Secondly, both the inventory turnover ratio and the DSI can be influenced by factors other than inventory management. For example, issues with transport may leave companies unable to sell products simply because they cannot deliver them to buyers.
By contrast, special offers can see products sell much more quickly than usual. This can make a ratio look excellent but can lead to a company sacrificing its profit margins.