Quick Guide: The Inventory Turnover Ratio
Our inventory turnover calculator is a useful tool to help you calculate a company's inventory turns more quickly, but it takes more than just the calculator to use it effectively during your financial analysis.
In this article we’ll dive into the important details that will help you calculate and use the inventory turnover ratio to enhance your financial analysis.
We’ll cover a few main points, including:
- How the inventory ratio is calculated and what it measures,
- Provide an example to further enhance your understanding of the ratio, and;
- Summarize a quick overview of our 5 step process for analyzing inventory turns.
With the inventory turnover ratio calculator, a good understanding of the ratio, and your brainpower, you'll have everything you need to effectively and efficiently analyze how a company is managing its inventory.
How to calculate inventory turnover
The inventory turnover ratio is calculated by taking a company’s cost of goods sold (often referred to as cost of sales) during a period and dividing that amount by the average inventory during that period.
Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory
Average inventory used in the above formula is calculated using the following formula:
Average Inventory Formula = (beginning inventory + ending inventory) / 2
What does the inventory turnover ratio measure
This ratio is part of a larger family of financial ratios known as asset management ratios, or efficiency ratios, which measure how effectively and efficiently a company is managing its assets to produce sales and generate returns for shareholders (check out our deep dive into asset management ratios, which you can use to further understand how these ratios impact your financial analysis).
The inventory turnover ratio specifically focuses on how quickly a company’s inventory is sold and whether the company produces and stores inventory for long periods of time, or produces and sells that inventory quickly.
Evaluating a company’s inventory turnover ratio will give you a good idea of how a company is managing its inventory levels, the sales demand for a company’s products, and how quickly the company turns inventory into sales.
What is a good inventory turnover ratio
Analyzing whether a company's ratio is strong depends on various factors, including the nature of the company’s operations, the trend of the company’s ratio over time, and how the company measures up to its peer group and industry competitors.
In most cases, the higher the ratio, the better. A higher ratio indicates a company is selling their inventory quickly and they are doing a good job of managing their production and sales - both good signs!
If a company's ratio is low, or slowing compared to the company’s historical inventory turns, that could be an indicator that the company’s sales are slowing, or they aren’t managing their inventory levels effectively.
The worst case scenario is that a company could have significant excess inventory, which could result in the inventory expiring or going obsolete before the company is able to sell it all. Not good!
Those are only general guidelines.
In order to use this ratio to understand how a company is performing, and use that information to confidently make a decision requires further analysis.
The 5 steps for powerful financial ratio analysis
Analyzing financial ratios can be difficult, and knowing where to start and how to complete your analysis prevents some people from ever getting started.
We'll touch on five key steps to simplify your analysis of a company's inventory turns below.
If you're interested in learning more about financial ratio analysis, including examples of how to complete and interpret the results of your analysis, we've covered this framework and walked through the below steps in greater detail here.
1. Analyze the Historical Trends of the Company
The first step in your analysis is to see what you can learn from the historical results of the Company. Once you know where a company currently stands, you can use this information to evaluate whether there are positive or negative trends that could impact the future results of the company.
2. Identify the Company’s Industry and Sector
The second step in your analysis is to research the company and identify its industry and sector. A good place to start is a company’s Standard Industrial Classification (“SIC”) Code. You can find this information in a company’s SEC filings and check out a full list of reported sectors here.
For broader industry categories, using an advanced stock screener or other research tools should give you what you need.
3. Understand the Nature of the Company’s Operations
Not all companies within the same industry or SIC classification would be a competitor of the company you are evaluating. A few examples of key characteristics to consider in your analysis are:
- Customer Base
- Life cycle of the Company
Once a company’s industry and key operating characteristics are identified, the next step is building up a list of companies with similar operations to use as a peer group in your analysis.
4. Define the Company’s Industry and Peer Group
The goal of identifying and grouping companies with similar characteristics is to use this list to accurately compare and benchmark one company’s ratio, against another. If you don’t get this part of your analysis right, it can lead to misinterpretations down the road.
There are several ways you can track down the information needed to form a peer group. Various tools and stock screeners on the web should have the information needed to analyze multiple companies. We covered this process in greater detail in our article that walks through how to use DiscoverCI’s stock screener to quickly find and evaluate a company’s peer group.
5. Evaluate How the Company’s Inventory Turns Measure Up
At this point we’ve calculated the company’s inventory turnover, we know how the Company’s inventory turns are trending over time, and we also have a solid list of comparable companies. The next step is reviewing the financial statements and ratios of the company and its peer group to see where the company lands.
An example of the inventory turnover ratio
Let’s take a look at a quick example (numbers in thousands, $USD):
Apple Inc. (AAPL) reported net inventory of $4,855,000 and $2,132,000 at September 30, 2017 and 2016, respectively. During FY2017 they also reported cost of goods sold of $141,048,000.
Using the formulas we outlined above, you would first calculate average inventory:
3,493,500 = (4,855,000 + 2,132,000) / 2
Which you would then use to calculate inventory turns:
40.37 = 141,048,000 / 3,493,500
To give you an idea of how Apple’s inventory turnover ratio stacks up to one of its competitors, below is a chart of Apple’s historical inventory turns compared to Amazon:
Evaluating a company’s inventory turnover ratio will give you insight into whether a company is doing a good job of managing its inventory levels and selling that inventory to customers at a high rate.
Strong companies manage their inventory and sales channels effectively, and avoid building up inventory and holding it at their warehouses for long periods of time.
And as smart value investors know, inventory management and sales are a key part of a fundamentally sound company.
You are now set with the inventory turnover calculator, as well as the understanding and brainpower you need to calculate and analyze a company’s inventory turnover ratio, but don’t stop there!