Inventory Turnover Ratio

What is the Inventory Turnover Ratio?

Inventory Turnover is a financial metric used to show how many times the inventory of a company is turned into goods, sold, and repurchased over a given period. It essentially measures how effective a company is at converting its inventory into sales, and displays the effectiveness of the business' inventory control and management efforts.

The Inventory Turnover Ratio provides useful information to shareholders that determine the efficiency of the company. A low value of inventory turnover may represent poor sales or possibly excess inventory, which can create cash flow issues if it gets too bad.

A few examples of these increased expenses are:

  • The cost of obsolescence
  • Warehousing and storage costs
  • Utility costs
  • Insurance costs
  • Opportunity costs

On the other end of the spectrum, a high value of inventory turnover represents a strong sales technique where inventory is being sold quickly. This demonstrates that there is sufficient demand for their product and gives shareholders comfort knowing that the company is efficient at managing their inventory levels and minimizing the risk with the inventory they hold.

 

Formula for Inventory Turnover

There are 2 formulas you can use to calculate inventory turnover:

inventory-turnover-ratio-formula

Inventory-turnover-ratio-formula

However, the first formula is usually more widely used by financial analysts as it reflects what items in inventory actually cost a copmany.

The inventory turnover ratio can be analyzed to compare the efficiency of different businesses that are within the same industry and of similar size in managing and selling their inventory.

Interestingly, the industry sectors with the highest average inventory turnover ratio, according to CSI markets as of Q3 2021, are:

Inventory-turnover-ratio-average-by-industry-sector
Source: CSI Markets

The financial and services industry sectors have the highest inventory turnover ratio, due to the intangible nature of their operations. In other words, they just don't hold a lot of physical inventory. The ratios of 53.25 and 31.82 mean that the Financial and Services industry sectors can replenish their ordinary inventory an average of 53 and 31 times a year, respectively.

Days Sales of Inventory is a ratio related to inventory turnover and is used by financial analysts to determine the days it takes for a business to convert its inventory to sales. What exactly is Days Sales of Inventory though?
 

 

What is Days Sales of Inventory (DSI)?

DSI is a financial ratio that is similar to the inventory turnover ratio, although it measures the average number of days it takes for a business to convert its inventory to sales. A lower DSI is preferred, as it represents efficiency where the company takes a shorter time to sell off their inventory, with a higher DSI representing a longer duration.

The two formulas for the Days Sales of Inventory ratio are:

Inventory-turnover-days-sales-of-inventory-ratio-formula

Inventory-turnover--days-sales-of-inventory-ratio-formula

Using the previous table used for the average inventory turnover ratio by industry sector, we can use one of these formulas to determine the average Days Sales of Inventory ratio by industry sector, which is:

Inventory-turnover--days-sales-of-inventory-ratio-average-by-industry-sector

This showcases that the Financial sector is the fastest in turning its inventory into sales, taking them an average of 6 days to turn its inventory into revenue, however, this is pretty meaningless since shipping goods and holding inventory isn't their main business as they are primarily selling services and advice.

These definitions might be confusing, so here are a few examples to help consolidate the information:

 

Example of Inventory Turnover

Pyth Inc is a retail company that sells a wide range of products, including appliances, home renovation products, manchester, and furniture. In its 2020 annual report, it disclosed sales revenue of $23,500,000, a gross profit margin of 40%, and an average inventory of $2,400,000.

To calculate this, we must first recall the formula to obtain COGS, which is Revenue - Gross Profit (GP) = COGS. The GP can be found by multiplying the amount of revenue by the GP margin:

  • GP = 23,500,000 x 40% = $9,400,000

Now we can calculate COGS by subtracting GP from revenue:

  • COGS = 23,500,000 - 9,400,000 = $14,100,000

We can now find Inventory Turnover by using the first formula listed previously:

  • Inventory Turnover = 14,100,000 / 2,400,000 5.9

This value indicates that the company is not efficient in converting its inventory to sales, as the industry average inventory turnover ratio for retail is around 12, according to CSI Markets. This might indicate low purchasing levels, a surplus of inventory bought, and poor sales performance, implying potential underlying issues with the business.

 

An example of Days Sales of Inventory

Continuing the example above, we apply the formula for DSI to find the number of days Pyth Inc requires to convert their inventory to sales.

  • Therefore, DSI = (2,400,000 / 9,400,000) x 365 days ≈ 93 days

It takes Pyth Inc approximately 93 days to convert its inventory into sales, which according to the average days sales of inventory by industry sector table, is below average. This means they are not able to quickly turn their inventory into sales. This might be because of various reasons, some of which could be:

  • Excess inventory
  • Poor sales performance
  • Obsolete inventory they have yet to write down

Pyth Inc must address these potential issues, otherwise risk costs such as opportunity costs, storage costs, and all other costs that were outlined previously.

The following videos provide great explanations for the Inventory Turnover ratio and the Days Sales of Inventory ratio:

 

 

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