Inventory turnover ratio measures how efficiently or better say frequently entity has completed one complete cycle of inventory from purchase to sale. Higher frequency may mean higher sales and thus higher sales revenue. In accounting we call it inventory turnover rate or simple inventory turnover.
As inventory itself is a key asset, knowing about inventory helps us understand many aspects. Inventory itself is an investment held by inventory to make profits by selling it. High turnover suggests inventory is held for shorter time by the entity and sold quickly to customers. Shorter holding time eventually results in lesser holding costs. Thus entity is better off with high turnover as both revenue increase and holding decrease supports profitability and liquidity of entity.
Formula: Inventory Turnover Ratio
Inventory turnover is calculated using following formula:
Inventory turnover = Cost of goods sold / Average inventory
Example
PakAccountants Inc. has crossed 1 million sales mark last year. To support such feat 800,000 worth of cost of goods sold was incurred with the year end inventory of 20,000. Records show that entity had 30,000 at the start of the year. Calculate inventory turnover ratio
Solution:
Inventory turnover ration requires average inventory which can be calculated as follows:
Average inventory = [30,000 + 20,000] / 2 = 25,000
Inventory turnover = Cost of goods sold / Average inventory
= 800,000 / 25,000 => 32
Analysis and Interpretation
In the above example entity has inventory turnover of 32. Now is it good or bad can only be answered if we comparative information. For better understanding it is better to compare it against entities from the same industry as inventory turnover for one industry can be completely different from another. Even in same industry because of difference in nature of operations and objectives. For example, turnover of luxury sedans like Toyota Camry or Honda Accord is much higher than exotic sedans like Rolls Royce Phantom and Mercedes Maybach.
For our example if industry average is 20 then PakAccountants Inc.’s 32 is significantly good. Similarly it can be compared with entity’s previous period or with budgeted turnover as well. Suppose PakAccountants Inc.’s turnover last year was 25 then entity has better turnover this year, therefore resultant holding cost should also be lower.
However, to be definitive regarding turnover, one must observe inventory turnover with sales revenue. Usually higher turnover is favourable but this is opposite or atleast not that encouraging if high turnover is met by slower sales growth rate or no growth at all. In this case, high turnover means that entity is facing problems in procuring inventory and thus not meeting sales order on time and losing revenue. Therefore, inventory management needs to be reviewed and purchase mechanism needs to be reworked.
Slower turnover indicates piling up of inventories either because of excessive purchase of inventory and thus stock levels rising. But again, care is needed as it is possible that entity had such inventory built up as it has plans to expand sales in the following year.
If entity’s turnover is lower than industry average then it may indicate obsolescence which may be temporary (e.g. season changed) or permanent (innovation, change of taste, fashion).
Factors Affecting Inventory Turnover Ratio: FIFO vs LIFO
Another factor that can vitally affect the turnover ratio is the way inventory is valued i.e. FIFO or LIFO methods of inventory valuation can alter the numbers considerably.
For example same company has following figures if calculations are done under FIFO and LIFO methods in times of rising prices:
FIFO method used:
Cost of Goods sold: 150,000
Opening inventory: 0
Closing inventory: 50,000
LIFO method used:
Cost of Goods sold: 300,000
Opening inventory: 0
Closing inventory: 20,000
Inventory turnover under FIFO basis: 150,000 / 25,000 = 6
Inventory turnover under LIFO basis: 300,000 / 10,000 = 30
Just because prices are rising and under LIFO basis cost of goods sold will be valued at higher price level and inventory based on old prices therefore can give completely different picture of the same company of the same period.