Inventory turnover is a financial ratio which indicates the resource tied up in inventory, therefore it measures how effectively the company manages its inventory.
We have two ways to calculate inventory turnover ratio. One using the cost of goods sold (COGS) and the other using sales in numerator. Few analysts believe that COGS should be used in place of sales as the latter include a markup over costs.
Cost of goods sold (COGS) include the cost of materials, salary and wages paid to labour directly related to goods, and any other costs that are directly related to goods.
Inventory turnover formula and calculation
Inventory turnover = Cost of goods sold / average value of inventory
Average value of inventory = (beginning inventory + ending inventory) / 2
Inventory of a company includes all the goods in stock including raw material, work-in-progress materials and finished goods that will ultimately be sold. Inventory turnover ratio of a year indicates the rate at which the company has sold and replaced its stock of goods during the year.
What inventory turnover ratio tells you
Higher inventory turnover indicates that inventory is held up for a short period of time or strong sales. To know how efficiently it’s managed by the company, you can compare inventory turnover with the industry standards.
If the inventory turnover is higher in comparison to industry standard, then it indicates that the company has effective inventory management. High inventory turnover with low days of inventory on hand (DOH) indicates that the company does not carry adequate inventory, therefore shortage could potentially hurt the company.
Slow growth combined with higher inventory indicate inadequate inventory levels.
Sales growth at or above industry standards indicate greater inventory management efficiency.
Low inventory turnover ratio indicates weak sales and possibly excess inventory, also known as overstocking.
Low inventory turnover with high DOH relative to the rest of the industry indicate slow moving inventory.