Inventory Turnover Ratio

Inventory turnover is the ratio of cost of goods sold by a business to its average inventory during a given accounting period. It is an activity ratio measuring the number of times per period, a business sells and replaces its entire batch of inventory again.

Formula

Inventory turnover ratio is calculated using the following formula:

Inventory Turnover =Cost of Goods Sold
Average Inventory

Cost of goods sold figure is obtained from the income statement of a business whereas average inventory is calculated as the sum of the inventory at the beginning and at the end of the period divided by 2. The values of beginning and ending inventory are obtained from the balance sheets at the start and at the end of the accounting period.

Analysis

Inventory turnover ratio is used to measure the inventory management efficiency of a business. In general, a higher value of inventory turnover indicates better performance and lower value means inefficiency in controlling inventory levels. A lower inventory turnover ratio may be an indication of over-stocking which may pose risk of obsolescence and increased inventory holding costs. However, a very high value of this ratio may be accompanied by loss of sales due to inventory shortage.

Inventory turnover is different for different industries. Businesses which trade perishable goods have very higher turnover compared to those dealing in durables. Hence a comparison would only be fair if made between businesses of same industry.

Examples

Example 1: During the year ended December 31, 2010, Loud Corporation sold goods costing $324,000. Its average stock of goods during the same period was $23,432. Calculate the company's inventory turnover ratio.

Solution
Inventory Turnover Ratio = $324,000 ÷ $23,432 ≈ 13.83

Example 2: Cost of goods sold of a retail business during a year was $84,270 and its inventory at the beginning and at the ending of the year was $9,865 and $11,650 respectively. Calculate the inventory turnover ratio of the business from the given information.

Solution
Average Inventory = ($9,865 + $11,650) ÷ 2 = $10,757.5
Inventory Turnover = $84,270 ÷ $10,757.5 ≈ 7.83

Written by Irfanullah Jan