Calculating Inventory Turnover Ratio
Learn the definition of inventory turnover ratio. Inventory turnover means how many times a business sells and replaces its inventory in a given period of time. A low turnover rate indicates unproductive assets and lower profits. The company is holding on to too much excess inventory because it is not selling fast enough. A high turnover rate may be an indication of lost sales as products may be out of stock when a customer wants to buy them. The components of the formula are cost of goods sold (COGS) and average inventory. The formula for calculating the inventory turnover ratio is C O G S / A v e r a g e I n v e n t o r y {\displaystyle COGS/AverageInventory} COGS/AverageInventory. Inventory can also be calculated by dividing sales by inventory.
Determine the cost of goods sold. The cost of goods sold is the direct expense associated with providing a service or producing a product. For the service industry, cost of goods sold includes labor expenses, including wages, taxes and benefits. In retail or wholesale, the cost of goods sold is comprised of merchandise that was purchased from a manufacturer, plus the expenses associated with acquiring, storing, and displaying inventory items. The cost of goods sold is recorded on the income statement. It is recorded as a deduction of revenue and determines the company’s gross margin. It is typically calculated with the formula B e g i n n i n g I n v e n t o r y + P u r c h a s e s − E n d i n g I n v e n t o r y = C O G S {\displaystyle BeginningInventory+Purchases-EndingInventory=COGS} BeginningInventory+Purchases-EndingInventory=COGS For example, suppose in a 12 month period, a company has a beginning inventory of $9,000, $20,000 in purchases and an ending inventory of $3,000. Calculate the COGS with the formula $ 9 , 000 + $ 20 , 000 − $ 3 , 000 = $ 26 , 000 {\displaystyle \$9,000+\$20,000-\$3,000=\$26,000} \$9,000+\$20,000-\$3,000=\$26,000. The COGS for that 12 month period is $26,000, and it would be recorded as an offset to revenue on the income statement.
Determine the average inventory. Average inventory is the median value of inventory within an accounting period. The value of inventory may change significantly within an accounting period. Therefore, it makes sense to calculate the average inventory when comparing inventory to total sales or cost of goods sold. This calculation eliminates confusion from spikes in the inventory level. The formula for average inventory is B e g i n n i n g I n v e n t o r y + E n d i n g I n v e n t o r y / 2 {\displaystyle BeginningInventory+EndingInventory/2} BeginningInventory+EndingInventory/2. For example, suppose in a 12 month period, a company had a beginning inventory of $9,000 and an ending inventory of $3,000. Calculate the average inventory with the formula $ 9 , 000 + $ 3 , 000 / 2 = $ 6 , 000 {\displaystyle \$9,000+\$3,000/2=\$6,000} \$9,000+\$3,000/2=\$6,000.
Apply the formula to calculate the inventory turnover ratio. Once you know the COGS and the average inventory, you can calculate the inventory turnover ratio. Using the information from the above examples, in this 12 month period, the company had a COGS of $26,000 and an average inventory of $6,000. To calculate the inventory turnover ratio, you would divide the COGS by the average inventory. $ 26 , 000 / $ 6 , 000 = 4.33 {\displaystyle \$26,000/\$6,000=4.33} \$26,000/\$6,000=4.33 This company sold and replaced its inventory 4.33 times in the 12 month period.
Calculating Days in Inventory
Learn the meaning of days in inventory. Once you know the inventory turnover ratio, you can use it to calculate the days in inventory. Days in inventory is the total number of days a company takes to sell its average inventory. It also determines the number of days for which the current average inventory will be sufficient. Companies use this metric to evaluate their efficiency in using their inventory.
Apply the formula to calculate days in inventory. You calculate the days in inventory by dividing the number of days in the period by the inventory turnover ratio. In the example used above, the inventory turnover ratio is 4.33. Since the accounting period was a 12 month period, the number of days in the period is 365. Calculate the days in inventory with the formula 365 / 4.33 = 84.2 {\displaystyle 365/4.33=84.2} 365/4.33=84.2. It takes this company 84.2 days to sell its average inventory.
Apply an alternate formula. If you have not calculated the inventory turnover ratio, you could simply use the cost of goods sold and the average inventory figures. You would divide the average inventory by the COGS. Then you would multiply that number by the number of days in the accounting period. In the example used above, the average inventory is $6,000, the COGS is $26,000 and the number of days in the period is 365. Calculate the days in inventory with the formula ( $ 6 , 000 / $ 26 , 000 ) ∗ 365 = 84.2 {\displaystyle (\$6,000/\$26,000)*365=84.2} (\$6,000/\$26,000)*365=84.2 You still get the same answer. It takes this company 84.2 days to sell its average inventory.
Analyzing Days in inventory
Examine the cash conversion cycle. The cash conversion cycle measures the number of days it takes a company to convert its resources into cash flow. Days in inventory is the first of three parts for this calculation. The second is the days sales outstanding, which is the number of days it takes the company to collect on accounts receivable. The third part is the days payable outstanding, which states how many days it takes the company to pay its accounts payable. The cash conversion cycle follows cash as it is first turned into inventory and accounts payable, then into sales and accounts receivable, and finally back into cash again. It measures the effectiveness of the company’s management. Having a quick cash conversion cycle shows that management has devised ways to reduce time wasted by the business by keeping items in inventory for a short time and getting payment for goods quickly. Doing both of these requires tightly managed and carefully planned systems.
Evaluate inventory effectiveness. The number of days in inventory expresses how long a company holds on to its inventory. This clarifies how long a company’s cash is tied up in its inventory. The longer a company holds on to its inventory, the more chances it has of losing money on that investment. Items in inventory can become outdated or they can expire. Also, prices can fall, which devalues the inventory. Holding inventory for a long period also educes return on investment, as excess capital is tied up in inventory during this time.
Compare your company’s days in inventory with other businesses in the same industry. The number of days in inventory makes more sense as a measure of effectiveness if you compare it with that of other businesses in the same industry. Different kinds of businesses sell their inventory at different rates. Retailers who sell perishable items have a smaller number of days in inventory than a company that sells cars or furniture. Therefore, compare your days in inventory with other businesses in the same industry to determine if you are selling your inventory efficiently. You can also compare your days in inventory with your own historical inventory days calculations. This will help you identify trends, positive or negative, that might be affecting your cash conversion cycle duration.
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