Why is inventory turnover important?

Definition of Inventory Turnover

A company's inventory turnover is often expressed as the company's cost of goods sold for a year divided by the average cost of inventory during the same year. The result of this calculation is the inventory turnover ratio.

Examples of Inventory Turnover

If a company's cost of goods sold for the most recent year was $600,000 and its inventory during that year was $150,000 the inventory turnover was 4 times. This mean the inventory on average was converted to cash four times during the year. If the cost of goods sold was $300,000 and the average inventory was $150,000 the inventory on average turned to cash only 2 times during the year.

When inventory items are slow to be converted into cash, the company's money is sitting in goods instead of in the company's checking account where it can be used to pay suppliers, employees, lenders, and others.

Monitoring the inventory levels (total amount and individual items) may result in:

  • Reducing the number of units purchased or produced to match lower customer demand
  • Reducing the number of items that could become obsolete or deteriorate
  • Reducing the need for warehouse space and other costs of holding/carrying inventory

While inventory is critical to meet demand for the goods, but having too much of the wrong inventory items can result in cash flow problems that may jeopardize the company's future.