For most business managing inventory levels is vital, particularly for retailers and any company that sells physical goods. The inventory turnover ratio shows a key measure for evaluating the efficiency of the management at managing company inventory and generating sales from it.
Before going into deeper on the calculation, let us examine the inventory turnover ratio first. Inventory turnover is a ratio showing how many times a company’s inventory is sold and replaced over a period of time. It is an efficiency ratio that shows how effectively inventory is managed by comparing the cost of goods sold with average inventory for a period of time. This measures how many times average inventory is “turned” or sold during a period.
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What does it mean?
Inventory turnover calculates how fast a company is selling inventory compared to industry averages. A low turnover means weak sales and, therefore, excess inventory. A high ratio refers to either good sales and/or large discounts.
The speed with which a company can sell inventory is a critical measure of business performance. It is also an important component for calculating the return on assets (ROA) and profitability. The return of a company makes on its assets is a function of how fast it sells inventory at a profit. It is important to remember, high turnover means nothing unless the company is making a profit on each sale.
What factor influen
ce the ratio?
This ratio depends on two main components of business performance, which are stock purchasing and sales.
The first component is stock purchasing. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of inventory to improve its turnover. If the company cannot sell these greater amounts of inventory, as consequence, it will incur storage costs and other holding costs.
The second component is sales. Sales have to match inventory purchases otherwise the inventory will not turn effectively. Therefore, it is important that the purchasing and sales departments must be in tune with each other.
How is the calculation?
Like a common turnover ratio, the calculation of inventory turnover ratio is as follows:
Cost of Goods Sold ÷ Average Inventory Or Sales ÷ Inventory
Usually, a higher inventory turnover ratio is preferred, because it shows that more sales are being generated given a certain amount of inventory. Alternatively, for a given amount of sales, using less inventory to do so will improve the ratio.
Sometimes a very high inventory ratio could result in lost sales, as there is not enough inventory to meet demand. It is always imperative to evaluate the inventory turnover ratio to the industry benchmark to assess if a company is successfully managing its inventory.
Days Sales of Inventory (DSI) or Days Inventory
To put into perspective, the ratio cannot be stand alone. The inventory turnover ratio can be calculated further with the amount of period of time by calculating days sales of inventory (DSI), also known as days inventory. It is simply the inverse of the inventory turnover ratio multiplied by 365. The calculation is as follows.
(Average Inventory ÷ Cost of Goods Sold) x 365
DSI significantly changes between industries and it is important to compare it against similar companies. Businesses that sell consumable products like supermarkets or groceries stores usually have lower inventory days than businesses that sell furniture or appliances.
To illustrate, for the fiscal year ended Jan. 2016, Wal-Mart Stores Inc (WMT) reported annual sales of $482.13 billion, year-end inventory of $44.47 billion, and the annual cost of goods sold (or cost of sales) of $360.98 billion.
Its inventory turnover for the year equals: $360.98 billion ÷ $44.47 billion = 8.12
Putting days into inventory calculation it equals: (1 ÷ 8.12) x 365 = 45 days.
This means that Wal-Mart sells its entire inventory within a 45-day period, which is quite impressive for such a large, global retailer.
The inventory turnover ratio is one of the best indicators of how efficiently a company is turning its inventory into sales. Even better, the day inventory ratio puts it into a daily context.
