What does the Inventory Turnover Ratio mean?

The inventory turnover ratio shows how often a business sells its goods compared to its cost of goods sold (COGS) during a specific period. After that, a business can divide the number of days (usually a fiscal year) by the inventory turnover ratio to determine how long it usually takes to sell its stock.

Businesses can use the inventory turnover ratio to help them make better choices about price, production, marketing, and buying. This is one of the efficiency rates that shows how well a business uses its resources.

Inventory Turnover Formula and How to Figure It Out

Stock Turnover = Cost of Goods Sold / Average Value of Stockin, which places as “cost of goods sold.”Inventory Turnover = Average Value of StockCOGS in places like COGS, which stands for “cost of goods sold.”​

Cost of sales is another name for cost of goods sold (COGS). Analysts use COGS instead of sales in the formula for inventory turnover because inventory is usually priced at what it costs. In contrast, sales include the markup the company puts on the goods. Some businesses might figure out the number by using sales instead of COGS, making it look higher than it is.

Second, the average value of goods is used to cancel out the effects of seasonality. If you add up the inventory value at the end of one period and divide it by the inventory value at the end of the previous period, you get this number.

What Can the Turnover of Your Stock Tell You?

Inventory turnover shows how often a business replaces its stock compared to how much it costs to sell. Most of the time, a larger ratio is better.

If your inventory turnover rate is low, it could mean that sales are slow or you have too much product, also called “overstocking.” It could mean a store chain’s marketing or merchandising plan isn’t working well.

On the other hand, a high inventory turnover percentage means that sales are going well. Alternatively, it could be because there isn’t enough product. Making sure a business has enough inventory to support strong sales is a better problem than reducing inventory because business is slow.

A low inventory turnover ratio can be helpful during times of inflation or supply chain problems, as long as more merchandise is bought before prices go up from suppliers or demand goes up. During the first year of the COVID-19 pandemic, retail stocks dropped sharply. This made it hard for the industry to meet demand during the recovery.

One meaningful way to judge how well a business is doing is by how quickly it can sell its stock. Stores that can turn their stock into sales more quickly usually do better than their similar competitors. It costs more to hold on to an item of goods for longer, and customers are less likely to come back to shop.

One case is the fast fashion business. Competitors like H&M and Zara usually limit runs and quickly add new things to replace sold-out items. Things that don’t sell quickly have higher keeping costs. Low product turnover also costs money in the form of missed opportunities. If an item takes a long time to sell, it takes longer to stock up on new items that might be more popular.

A drop in the inventory change ratio could mean less demand, which would cause companies to make less.

Stock Turnover and Dead Stock

When selling perishable or other time-sensitive things, inventory turnover is one of the most critical information you can have. Things like food, clothes, cars, and magazines are examples.

For example, having too many cashmere sweaters could mean lost earnings and unsold goods, significantly as the seasons change and stores restock to match. Stock that hasn’t been sold in a while is called outdated inventory or dead stock.

Related Ratios for Stock

If you compare stockpiles to net sales instead of the cost of sales, you get the inventory-to-saIes ratio, which is the opposite of the inventory turnover ratio.

Days sales of inventory (DSI) is another measure that shows the opposite of inventory turnover. It shows the average number of days it takes to sell an item. To find DSI, split the average value of your inventory by the cost of goods sold (COGS) and multiply by 365.

Example of How to Figure Out Inventory Turnover

It’s called Walmart Inc.

Walmart Inc. (WMT) said that its cost of sales was $429 billion, and its year-end inventory was $56.5 billion, up from $44.9 billion the previous year.6

For the year, Walmart’s inventory change rate was:

$429 billion ÷ [1/2 of $56.5 billion and $44.9 billion]that’s about 8.5

Its days’ worth of stock was:

(365 x 8.5), which is about 42 days

This showed that, on average, Walmart changed its stock every 42 days over the year.

How does inventory turnover work? What are its limits?

Because the ratio changes so much from industry to industry, inventory turnover is only suitable for comparing similar companies. In 2021, for example, publicly traded U.S. car dealers changed their stock every 55 days on average, while publicly traded food store chains only did it every 23 days.

A high inventory turnover rate could mean the company doesn’t have enough, hurting sales. On the other hand, a low inventory turnover rate could mean that the company is getting ready for a product launch or ordering in bulk to save money.

Since cost of sales (COGS) is used in the numerator of the inventory turnover ratio, the result is very dependent on how the company accounts for costs and is affected by changes in costs. For instance, a cost pool transfer to inventory could be recorded as an expense in later periods. This would change the average inventory value used in the inventory turnover ratio denominator.

On the other hand, if discounts or closeouts cause the product turnover ratio to rise, profits and return on investment (ROI) may go down.

How do you figure out the Turnover of your inventory?

To determine how well a business uses its stock, divide its cost of sales, also known as cost of goods sold (COGS), by the average value of its stock over the same period. For stores, this efficiency number is significant.

How Often Should I Turn Over My Stock?

What a “good” inventory turnover rate for a specific business is will depend on what the standard is. In general, businesses selling cheap goods will have higher inventory change rates than those selling expensive goods.

If you have a lot of inventory, is that good or bad?

A high product turnover is something that almost all businesses will want. Ultimately, having a lot of inventory on hand means they have less cash locked up in it. Also, it helps the business make more money by bringing in more money compared to set costs like rent and wages. But sometimes, a high product turnover can mean that the company lacks enough stock, preventing sales.

How can the Turnover of inventory be made better?

Some stores use inventory management tools or open-to-buy purchase budgeting to make sure they have enough stock to make the most sales without wasting money or taking risks that aren’t necessary. Companies with short production lead times and localized supply chains also use pull-through production systems. This system buys the materials for production but doesn’t start making the product until a customer gets it.

Conclusion

• By dividing the cost of goods sold by the average inventory value during the time, inventory turnover shows how well a business uses its stock.
• Inventory turnover ratios are only good for comparing businesses that are very much the same. This is especially true for stores.
• A low inventory turnover ratio could mean that sales are slow or too much inventory. On the other hand, a high ratio could mean that sales are good but inventory is not stocked enough.
• Comparing inventory turnover rates can be challenging because of accounting rules, quickly changing prices, and changes in the seasons.