Inventory Turnover Ratio: What It Is, How It Works, and Formula

What Is the Inventory Turnover Ratio?

The inventory turnover ratio is a financial ratio showing how many times a company turned over its inventory relative to its cost of goods sold (COGS) in a given period. A company can then divide the days in the period, typically a fiscal year, by the inventory turnover ratio to calculate how many days it takes, on average, to sell its inventory.

The inventory turnover ratio can help businesses make better decisions on pricing, manufacturing, marketing, and purchasing. It is one of the efficiency ratios measuring how effectively a company uses its assets.

Understanding the Inventory Turnover Ratio

The inventory turnover ratio is a really useful financial metric, especially for those companies that has inventory. It measures the number of times a company's inventory is sold and replaced over a specific period, typically a year. A higher inventory is usually better, though there may be downsides to a high turnover.

Like most other ratios, analyzing the inventory turnover ratio in conjunction with industry benchmarks and historical trends provides valuable insights into a company's operational efficiency and competitiveness. On its own, the turnover ratio may not mean much. However, tracking it over time or comparing it against another company's ratio can be more insightful.

Inventory Turnover Formula and Calculation

The inventory turnover ratio is calculated as follows:

$\begin{aligned} &\text{Inventory Turnover} = \frac{ \text{COGS} }{ \text{Average Value of Inventory} } \\ &\textbf{where:} \\ &\text{COGS} = \text{Cost of goods sold} \\ \end{aligned}$​Inventory Turnover=Average Value of InventoryCOGS​where:COGS=Cost of goods sold​

Cost of goods sold (COGS) is also known as cost of sales. Analysts use COGS instead of sales in the formula for inventory turnover because inventory is typically valued at cost, whereas the sales figure includes the company’s markup. Some companies may use sales instead of COGS in the calculation, which would tend to inflate the resulting ratio.

Secondly, average value of inventory is used to offset seasonality effects. It is calculated by adding the value of inventory at the end of a period to the value of inventory at the end of the prior period and dividing the sum by 2.

What Can the Inventory Turnover Ratio Tell You?

Inventory turnover measures how often a company replaces inventory relative to its cost of sales. Generally, the higher the ratio, the better.

A low inventory turnover ratio might be a sign of weak sales or excessive inventory, also known as overstocking. It could indicate a problem with a retail chain’s merchandising strategy or inadequate marketing. Generally speaking, a low inventory turnover ratio means the product is not flying off the shelf, so demand for the product may be low.

A high inventory turnover ratio, on the other hand, suggests strong sales. Alternatively, it could be the result of insufficient inventory. As problems go, ensuring a company has sufficient inventory to support strong sales is a better one to have than needing to scale down inventory because business is lagging.

The speed with which a company can turn over inventory is a critical measure of business performance. Retailers that turn inventory into sales faster tend to outperform comparable competitors. The longer an inventory item remains in stock, the higher its holding cost, and the lower the likelihood that customers will return to shop.

The fast fashion business is an example. Competitors including H&M and Zara typically limit runs and replace depleted inventory quickly with new items. Slow-selling items equate to higher holding costs. There is also the opportunity cost of low inventory turnover; an item that takes a long time to sell delays the stocking of new merchandise that might prove more popular.

A decline in the inventory turnover ratio may signal diminished demand, leading businesses to reduce output.

Inventory Turnover and Dead Stock

Inventory turnover is an especially important piece of data for maximizing efficiency in the sale of perishable and other time-sensitive goods. Examples include groceries, fashion, autos, and periodicals. An overabundance of cashmere sweaters, for instance, may lead to unsold inventory and lost profits, especially as seasons change and retailers restock accordingly. Such unsold stock is known as obsolete inventory, or dead stock.

The inventory turnover ratio may one way of better understanding dead stock. In theory, if a company is not selling a lot of one product, the COGS of that good will be very low (since COGS is only recognized upon a sale). Therefore, products with a low turnover ratio should be evaluated periodically to see if the stock is obsolete.

Related Inventory Ratios

The inventory-to-saIes ratio is the inverse of the inventory turnover ratio, with the additional distinction that it compares inventories with net sales rather than the cost of sales. A higher inventory-to-sales ratio suggests that the company may be holding excess inventory relative to its sales volume, meaning there may be inefficiencies in its inventory management. A lower inventory-to-sales ratio implies that the company has a leaner inventory position relative to its sales, which may reflect tighter control over inventory levels and/or more efficient allocation of resources.

Another ratio inverse to inventory turnover is days sales of inventory (DSI), marking the average number of days it takes to turn inventory into sales. DSI is calculated as average value of inventory divided by cost of sales or COGS, and multiplied by 365. Companies tend to want to have a lower DSI, and they usually want that DSI to be sufficient enough to cover short-term cash needs.

Limitations of the Inventory Turnover Ratio

The inventory turnover ratio is a valuable metric for many companies. However, there's a bunch of downsides to consider. Some of the limitations of the inventory turnover ratio include:

• Industry Variability: Different industries have varying norms and practices regarding inventory management. This means there's going to be natural differences in ideal turnover ratios. Comparing turnover ratios across industries without considering these differences can be misleading.
• Seasonal Fluctuations: Some businesses experience significant seasonal variations in demand, which can affect inventory turnover ratios. A high turnover ratio during peak seasons may skew the overall ratio, and companies may look worse even though they've adequately planned for the slower seasons.
• Cost Variations: The inventory turnover ratio is based on the cost of goods sold, which may fluctuate due to changes in production costs, raw material prices, or currency exchange rates. These fluctuations can impact the accuracy and comparability of turnover ratios over time.
• Overlooked Carrying Costs: While a high turnover ratio is generally seen as positive, it may overlook the costs associated with maintaining low inventory levels. For example, a company may incur high fees related to stockouts, rush orders, and lost sales opportunities for moving too fast. Businesses should consider the balance between inventory turnover and the associated carrying costs to optimize profitability.
• Ignoring Lead Times: The inventory turnover ratio does not account for lead times or the time it takes to replenish inventory. A high turnover ratio may indicate efficient sales, but if lead times are long, it could lead to stockouts and potential customer dissatisfaction if inventory is not replenished.

Example of an Inventory Turnover Calculation

For fiscal year 2022, Walmart Inc. (WMT) reported cost of sales of $429 billion and year-end inventory of $56.5 billion, up from $44.9 billion a year earlier. Walmart’s inventory turnover ratio for the year was:

2022: $429 billion ÷ [($56.5 billion + $44.9 billion)/2], or about 8.5

Its days inventory equaled, this was calculated as 365 ÷ 8.5, or about 42 days. This showed that Walmart turned over its inventory every 42 days on average during the year.

Fast-forward to 2024, Walmart reported cost of sales of $490 billion for the fiscal year ending January 2024. It also reported ending inventory of $54.9 billion as of 1/31/2024, down from $56.6 billion as of 1/31/2023. The inventory turnover ratio for 2024 was:

2024: $490 billion ÷ [($54.9 billion + $56.6 billion)/2], or about 8.8

This signals that from 2022 to 2024, Walmart increased its inventory turnover ratio. Management should further explore the cause; it may be due to more efficient processes, or it may be due to more demand for the products it offers. However, very generally speaking, the movement of this ratio from 2022 to 2024 appears to be positive.

Special Considerations

Inventory turnover is only useful for comparing similar companies, because the ratio varies widely by industry. For example, listed U.S. auto dealers turned over their inventory every 55 days on average in 2021, compared with every 23 days for publicly traded food store chains.

A relatively high inventory turnover ratio might indicate insufficient stocking that is costing the company sales, while low inventory turnover could reflect bulk orders helping the company cut costs or preparations for a product launch, rather than inefficient inventory management.

Because the inventory turnover ratio uses cost of sales or COGS in its numerator, the result depends crucially on the company’s cost accounting policies and is sensitive to changes in costs. For example, a cost pool allocation to inventory might be recorded as an expense in future periods, affecting the average value of inventory used in the inventory turnover ratio’s denominator. As is the case with other financial ratios, accounting practices do have an influence on results.

The Bottom Line

A company's inventory turnover ratio reveals the number of times a company turned over its inventory relative to its COGS in a given time period. This ratio is useful to a business in guiding its decisions regarding pricing, manufacturing, marketing, and purchasing. It is of particular importance in retail.