The calculation for the inventory turnover ratio is: Cost of Goods Sold for a Year divided by Average Inventory during the same 12 months.
To illustrate the inventory turnover ratio, let’s assume 1) that during the most recent year a company’s Cost of Goods Sold was $3,600,000, and 2) the company’s average cost in its Inventory account during the same 12 months was calculated to be $400,000. The company’s inventory turnover ratio is 9 ($3,600,000 divided by $400,000) or 9 times.
The higher the inventory turnover ratio, the better, provided you are able to fill customers' orders on time. It would be foolish to lose customers because you didn't carry sufficient inventory quantities.
A company's inventory turnover ratio should be compared to 1) its previous ratios, 2) its planned ratio, and 3) the industry average.
Even with a favorable inventory turnover ratio, a company may have some excess and obsolete inventory items. Therefore, it is wise to compare the quantity of each item in inventory with the recent sales of each item.
