Formula for Inventory Turnover Ratio

Formula For Inventory Turnover Ratio

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The formula for inventory turnover ratio is very simple, it can be calculated by dividing COGS (Cost Of Goods Sold) by Average Inventory. The inventory turnover ratio is a financial ratio that shows how many times a company has sold and replaced its inventory. One complete turnover means the company sold the inventory it had purchased. The formula for inventory turnover ratio is also useful to calculate days sales of inventory.

Formula for Inventory Turnover Ratio

Definition Of Inventory Turnover Ratio –

The inventory turnover ratio can be defined as the ratio of COGS to Average Inventory. It is a financial ratio that shows how many times a company has sold and purchased its inventory. The ratio helps to make an efficient decision regarding inventory purchasing, marketing, and manufacturing. It is also called a stock turnover ratio that helps to understand how efficiently a company is managing its inventory.

Formula For Inventory Turnover Ratio –

The formula for inventory turnover ratio is given below,

Invetory Turnover Ratio = COGS / Average Inventory

COGS – Cost Of Goods Sold

Average Inventory = ( Beginning Inventory + Ending Inventory ) / 2

Also, we can calculate how many average days it takes for a company to sell its entire inventory by using the below formula

Days Sales Of Inventory = ( Average Inventory / COGS ) * 365

OR

Days Sales Of Inventory = 365 / Inventory Turnover Ratio

COGS can be seen in the Profit and loss Statement and Inventory in the Balance Sheet.

Understanding Inventory Turnover Ratio –

The inventory turnover ratio is a financial ratio that is used by investors and analysts to analyze a company. This is one of the most important ratios like the asset turnover ratio. The ratio can be calculated by using COGS and Average Inventory. COGS includes any costs related to inventory such as labor costs, material costs, and production costs. Average inventory is nothing but the average of beginning and ending inventory.

The inventory turnover ratio can vary from industry to industry. It could be higher for FMCG and the fast fashion industry and it could be lower for the high-end goods industry. In short lower margin industries tends to have a higher turnover ratio while higher-margin industries tend to have a lower turnover ratio. A higher inventory turnover ratio shows the company is selling goods quickly and it also means reduced storage costs and other holding costs. A lower inventory turnover ratio shows poor sales or it shows the company is carrying too much inventory.

Example of Inventory Turnover Ratio –

PARTICULARCOMPANY ACOMPANY B
COGS200400
Beginning Inventory4060
Ending Inventory5066
Average Inventory4563
Inventory Turnover Ratio4.446.35

The above table shows the example of company A and company B,

Let’s take the example of company A,

COGS = 200

Average Inventory = ( Beginning Inventory + Ending Inventory ) / 2

Average Inventory = ( 40 + 50 ) / 2

Average Inventory = 90 / 2

Average Inventory = 45

Now we can calculate the inventory turnover ratio of company A, the formula for inventory turnover ratio is,

Inventory Turnover Ratio of company A = COGS / Average Inventory

Inventory Turnover Ratio of company A = 200 / 45

Inventory Turnover Ratio of company A = 4.44

By using the inventory turnover ratio, we can calculate days sales of inventory of company A,

Days Sales of Inventory (DSI) = 365 / Inventory Turnover Ratio

Days Sales of Inventory (DSI) = 365 / 4.44

Days Sales of Inventory (DSI) of company A = 83

Now, let’s take the example of company B,

COGS = 400

Average Inventory = ( Beginning Inventory + Ending Inventory ) / 2

Average Inventory = ( 60 + 66 ) / 2

Average Inventory = 126 / 2

Average Inventory = 63

Now we can calculate the inventory turnover ratio of company B, the formula for inventory turnover ratio is,

Inventory Turnover Ratio of company B = COGS / Average Inventory

Inventory Turnover Ratio of company B = 400 / 63

Inventory Turnover Ratio of company B = 6.35

By using the inventory turnover ratio, we can calculate days sales of inventory of company B,

Days Sales of Inventory (DSI) = 365 / Inventory Turnover Ratio

Days Sales of Inventory (DSI) = 365 / 6.35

Days Sales of Inventory (DSI) of company B = 58

Formula for Inventory Turnover Ratio

Meaning of Inventory Turnover Ratio =

The formula for inventory turnover ratio requires COGS and Average Inventory. We can get COGS from the P&L statement and Average Inventory from the balance sheet. The inventory turnover ratio of company A is 4.44 and company B is 6.35. The ratio shows that company B has a higher turnover ratio than company A which means company B is more efficiently managing its inventory than company A.

Also, the days sales of inventory of company A is 83 and company B is 58. It shows that company A sells its entire inventory within 83 days and company B in 58 days. So, company B is efficiently managing its inventory, and it also means company B is taking good decisions regarding inventory purchasing, manufacturing, and marketing.

Key Takeaways =

  1. The ratio helps to understand how the company is managing its inventory.
  2. The formula for inventory turnover ratio can be calculated by dividing COGS by Average Inventory.
  3. The formula for inventory turnover ratio helps to calculate days sales of inventory.
  4. Higher the ratio is better which means the company is selling its inventory quickly.
  5. Lower the ratio is not a good sign, it shows poor sales.
  6. The ratio varies from industry to industry.
  7. The ideal turnover ratio will be between 5 to 10.
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