What is the inventory turnover rate?

The Inventory Turnover Rate (ITR) is the formula that helps you understand how long it takes a business to sell its entire inventory. A higher inventory turnover rate usually means that the business has strong sales compared to a company with a lower turnover rate.

Definition and Examples of Inventory Turnover Rate

The inventory turnover rate is a simple way to know how often the company cycles through its inventory over a specific period of time. It is also known as “inventory cycles.” This formula provides insight into the efficiency of the company in converting its cash into sales and profits.

For example, a company like Coca-Cola can use the inventory turnover rate to see how quickly it sells its products compared to other companies in the same industry.

How Does the Inventory Turnover Rate Work?

You can save yourself a lot of trouble when looking for inventory turnover rates by checking the financial statement and income statement of the company. The cost of goods sold is usually mentioned in the income statement, and inventory balances can be found in the financial statement. Using these two documents, you simply need to plug the numbers into the formula.

Note: The inventory turnover rate is just one type of efficiency ratio, but there are many other ratios. When comparing the figures, remember that some analysts use total annual sales instead of the cost of goods sold. This is mostly the same formula, but it includes a company’s brand. This means it can lead to a different result than formulas that use the cost of goods sold.

Neither one is better than the other, but make sure you are consistent in your comparisons. You don’t want to use annual sales to find the percentage for one company while using the cost of goods sold for another. This won’t give you any real insight into how the two companies compare.

How to Calculate Inventory Turnover Rate?

The first step to find the inventory turnover rate is to select a time period for measurement (such as a quarter or fiscal year). Then find the average inventory for that period. You can do this by calculating the average inventory costs at the end and beginning of the specified time period. Once you have your time frame and average inventory, simply divide the cost of goods sold (COGS) by the average inventory.

Example of Calculating Inventory Turnover Rate

Let’s take this practical example: Coca-Cola’s income statement for 2017 showed that the cost of goods sold (COGS) was $13.256 million. The average inventory value between 2016 and 2017 was $2.665 million. We can use these numbers to find the ratio:

Inventory Turnover Rate = Cost of Goods Sold / Average Inventory

Inventory Turnover Rate = $13.256 million / $2.665 million

Inventory Turnover Rate = 4.974

Now you know that Coca-Cola’s inventory turnover rate for that year was 4.974. You can compare this with other companies in the beverage and snack industry to see how well Coca-Cola is doing. For example, suppose you found that a competitor’s inventory turnover rate was 8.4. This would indicate that the competitor is selling products faster than Coca-Cola.

There are many reasons that could lead to a company having a lower inventory turnover rate compared to another company. That doesn’t always mean that one company is worse than the other. Be sure to read the company’s financial data and any notes for a complete picture.

Although Coca-Cola’s inventory turnover rate was lower, you may find other metrics that show it is still stronger than the averages of other companies in its industry. Historical data can also be used to compare current years with previous years to provide useful context.

Limitations

Inventory Turnover Rate

The time it takes a company to sell its inventory can vary significantly by industry. If you are not aware of the average inventory turnover for the relevant industry, the formula won’t help you much.

For example, retail stores and grocery chains typically have a much higher turnover rate. This is due to selling lower-cost products that spoil quickly. As a result, these businesses require much greater management effort.

On the other hand, a company that manufactures heavy equipment, like airplanes, will have a much lower turnover rate. It takes a long time to manufacture and sell an airplane, but once the sale is closed, it often brings in millions of dollars for the company.

Source: https://www.thebalancemoney.com/calculate-inventory-turnover-357280

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