The inventory turnover ratio tells the analyst how well a company manages its inventory. This metric requires data from both the income statement (revenues) and balance sheet (inventory).
Inventory Turnover = Revenues (or Cost of Goods Sold) / Average Inventory
As the above formula demonstrates, the numerator of this equation contains one of two values:
- All of the revenues flowing into the company each year, or
- All of the costs to produce the items that will eventually flow through inventory
The cost of goods sold variation provides the analyst with a clearer picture of inventory turnover.
When examining an income statement, the value for the costs of good sold includes all of the items that have been transferred out of inventories during any fiscal reporting period. This means there is a strong relationship between the cost of goods sold and the inventories maintained throughout the year. The inventory turnover ratio tells the analyst and investor how many times inventories are replaced each year.
A high value for inventory turnover usually accompanies a low gross profit figure. A high ratio means that a company needs to sell a lot of items to maintain an adequate return on the capital invested in the company. If inventory turnover is too high, it may be an indication the company is losing sales due to inadequate inventories.
When drawing conclusions about the relative performance of a company, benchmark comparisons should be made with competitors in the same industry.
Company A’s income statement indicates cost of revenues (another name for cost of goods sold) of $15,693,000. To find the average inventory for the current year, the ending inventory for two years is needed (the current year and the prior year). The two values found on the balance sheet are $3,416,000 (current year) and $3,155,000 (previous year). The calculation of the inventory turnover ratio would be:
= $15,693,000 / (($3,416,000 + $3,155,000)/2) = $15,693,000 / ($6,571,000 / 2) =$15,693,000 / $3,285,500, or 4.78