Definition of Inventory Turnover Ratio
The inventory turnover ratio is an important financial ratio that indicates a company's past ability to sell its goods. Converting inventory into cash is critical for a company to pay its obligations when they are due.
The calculation for the inventory turnover ratio is: cost of goods sold for a year divided by average inventory during the same 12 months. A higher inventory turnover ratio is viewed as better than a lower ratio.
Note: The cost of goods sold is used (not sales) in calculating the inventory turnover ratio because the company's inventory is recorded and reported at its cost (not at its selling prices). However, be cautioned that some people will use sales and therefore will be overstating the inventory turnover ratio. It is also important to use the average amount of inventory throughout the entire year since using only the end-of-the-year amounts may result in a much lower average.
Example of Inventory Turnover Ratio
To illustrate the inventory turnover ratio, let’s assume that during the most recent year a company’s cost of goods sold was $3,600,000 and the average cost of its inventory account during the year was $400,000. As a result, the company’s inventory turnover ratio is: cost of goods sold of $3,600,000 divided by average inventory of $400,000 = 9 times during the recent year. This could be compared to the company's ratio in previous years and to other companies in the same industry.
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 to the quantity of each item sold during the past year.