Master the Inventory Turnover Ratio: Definition, Formula, and Practical Strategies

It measures how many times a company has sold and replaced its inventory during a certain period of time. For example, having an inventory turnover ratio of 10 means the firm has sold and refilled its average inventory 10 times during the period selected for analysis. The inventory turnover ratio formula is calculated by dividing the cost of goods sold for a period by the average inventory for that period. The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing cost of goods sold with average inventory for a period. This measures how many times average inventory is “turned” or sold during a period. In other words, it measures how many times a company sold its total average inventory dollar amount during the year.

Key Insights:

If you want to measure how well your inventory management processes are working, calculating inventory turnovers is essential. By optimizing your turnover ratio, you reduce waste, improve sales efficiency, and ultimately increase profit margins. This example illustrates the fact that ratio analysis is useful when companies’ ratios are compared with other firms in the same industry or across different periods for a single company. However, a very high value of this ratio may result in stock-out costs, i.e. when a business is not able to meet sales demand due to non-availability of inventories. Inventory turnover ratio is used to assess how efficiently a business is managing its inventories.

A higher ITR means your inventory is moving quickly, which is usually indicative of strong sales. However, it needs to be balanced—too high, and you’re at risk of stockouts, too low, and you might be piling up unsold goods. The inventory turnover ratio shows how often a company has sold and replaced inventory during a given period. Calculating this ratio can help businesses make better decisions on manufacturing, pricing, marketing, and purchasing new inventory. Depending on your industry, a slow turnover may imply weak sales or possibly excess inventory, whereas a fast turnover ratio can indicate either strong sales or insufficient inventory. It reports a net sales revenue of $75,000 and a gross profit of $35,000 on its income statement for the year 2022.

When your ITR is excessively high, it could mean you’re operating on razor-thin margins of inventory. This can lead to stockouts, resulting in missed sales opportunities and dissatisfied customers who might turn to competitors. Moreover, it might strain your supply chain, leading to logistic hurdles. Essentially, while a high ITR suggests brisk sales, too high could be a red flag for overstretched resources.

It reflects the movement of older, possibly cheaper stock, making the ratio appear stronger in inflationary times. Average inventory is an estimated amount of inventory that a business has on hand over a longer period. As the name suggests, it is calculated by arriving an average of stock at the beginning and end of the period.

Cost of goods sold (COGS)

You don’t want your merchandise gathering dust; however, you don’t want to have to restock inventory too often or risk having inadequate inventory to meet demand. The golden ratio is somewhere in between and varies from industry to industry—and often from product to product. The formula used to calculate a company’s inventory turnover ratio is as follows. The inventory turnover ratio is a financial metric that portrays the efficiency at which the inventory of a company is converted into finished goods and sold to customers.

• The Inventory Turnover Ratio, or ITR (a.k.a. stock turnover ratio) measures the number of times a business sells and replaces its inventory over a certain period.
• At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content.
• Other businesses have a much faster inventory turnover ratio, examples of which include petroleum companies.
• She has owned Check Yourself, a bookkeeping and payroll service that specializes in small business, for over twenty years.
• Inventory management software, or enterprise resource planning (ERP) software, can often be helpful in tracking inventory at a very detailed level.

Mental Notes for Inventory Turnover Ratio Formula

Extremely high turnover might mean the company is not maintaining enough inventory to meet demand, leading to stockouts and potential lost sales. In such cases, it would be beneficial to re-evaluate inventory levels and sales forecasts to maintain a healthy balance. By comparing your business’s inventory turnover ratio against these benchmarks, you can identify areas for improvement and adjust your inventory strategies accordingly. Understanding where you stand can help you make informed decisions that drive efficiency and profitability. For immediate access to a company’s inventory turnover rate, utilize the InvestingPro platform.

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Getting demand forecasting right is crucial for businesses looking to balance their inventory with actual customer demand. The inventory turnover ratio can be one way of better understanding dead stock. In theory, if a company is not selling a lot of a particular product, the COGS of that good will be very low (since COGS is only recognized upon a sale).

Implications of High vs. Low ITR

• Essentially, the formula helps you understand the effectiveness of your selling efforts and inventory management.
• That way, you can drive quicker sales with targeted promotions that ride your existing waves.
• The inventory turnover ratio is a financial metric that portrays the efficiency at which the inventory of a company is converted into finished goods and sold to customers.
• Also, a company might have an ultra-high ITR (in other words, strong sales) while going bankrupt because the company isn’t making enough profit on each sale.
• The less money tied up in stock, the more you have to reinvest in other areas of your business—whether it’s marketing, new products, or expansion.
• By integrating these strategies, businesses can enhance their inventory turnover ratio, ultimately leading to a more agile and profitable operation.

For example, retail inventories fell sharply in the first year of the COVID-19 pandemic, leaving the industry scrambling to meet demand during the ensuing recovery. Analyzing an inventory turnover ratio in conjunction with industry benchmarks and historical trends can provide valuable insights into a company’s operational efficiency and competitiveness. However, tracking it over time or comparing it against a similar company’s ratio can be very useful. A grocery store will have a higher inventory turnover rate than a business selling specialty packaged (non-perishable) gourmet foods, for example. Understanding how your business stacks up against others in your industry may be helpful to understand your business performance. What is a good inventory turnover ratio for your business and industry may be completely different from that of another.

Inventory turnover is an especially important piece of data for maximizing efficiency in the sale of perishable and other time-sensitive goods. An overabundance of cashmere sweaters, for instance, may lead to unsold inventory and lost profits, especially as seasons change and retailers restock accordingly. A decline in the inventory turnover ratio may signal diminished demand, leading businesses to reduce output. With the right software, you can monitor how much inventory you have and how much has been sold.

As a general rule of thumb, the higher the turnover ratio, the better — since it implies the company can generate more revenue with fewer assets. Therefore, by comparing the two sides — revenue and an asset metric — each “turnover” ratio measures the relationship between the two and how they trend over time. One can gauge a company’s ability to manage its current assets such as inventory and accounts receivable (A/R) as well as its long-term assets, or fixed assets (PP&E), to generate more revenue. An activity ratio, or asset utilization ratios, determines the efficiency at which a company utilizes its assets, and is an indicator of how efficient a company is at asset allocation. Costco serves as a prime inventory turnover ratio formula example in the retail industry regarding inventory turnover, consistently maintaining a ratio above 10, and often reaching up to 13, for over a decade. If you sold mobile phones worth $220,000 for $200,000, the revenue generated from selling the phones is $200,000.