Inventory turnover is an important activity ratio.
Activity ratios measure how effectively a business uses its resources, such as receivables collection, inventory, etc. They are also called efficiency ratios.
Inventory turnover ratio provides a measure of how effectively a business is using its inventory.
These ratios measure how many times the company’s inventory has been turned over or sold during a specified period.
For example, an inventory turnover ratio of 10 means that the inventory has been turned over 10 times in the specified period, usually a year. The Days of Inventory at Hand (DOH) specifies how many days worth of inventory the company had in hand. For example, DOH of 36 days means that the company had 36 days of inventory at hand during the period.
Cost of Goods Sold value is taken from the Income Statement and Inventory is taken from the Balance Sheet. Since the balance sheet tells the financial condition of a company at the end of the period, we take Average Inventory for the year in our calculation.
365 is the most commonly used day count convention however some analysts may prefer to use 360 days.
Assume that the cost of goods sold for a company for the previous year was $1,000,000 and the beginning and ending inventory for the year were 120,000 and 80,000.
This means that the company turns over its entire inventory 10 times during the year.
This means that on average the company had 36.5 days of inventory at hand.
Note that if the analyst is particularly interested in how much inventory was at hand at the end of the financial year, then he will use the closing inventory for the above calculation.
As you can see the Inventory Turnover and Days of Inventory at hand are inversly related. If inventory turnover is high, the DOH will be low and vice verse.
The ratio is compared with others in the industry to measure the performance.
A high inventory turnover ratio generally means that the company is managing its inventory effectively. It can also mean that the company has shortage of inventory which could actually impact the revenues. To identify which is the correct situation, the analyst will interpret this ratio in combination with revenue growth. If revenue growth is slow, and the inventory turnover is high, it indicates a shortage of inventory.
A low inventory turnover ratio, compared to its peers, could indicate that the company is not able to sell its inventory.