inventory turnover ratio formula and interpretation

It also implies that it would take Donny approximately 3 years to sell his entire inventory or complete one turn. This means that Donny only sold roughly a third of its inventory during the year. Donny’s turnover is calculated like this:Īs you can see, Donny’s turnover is. Donny’s beginning inventory was $3,000,000 and its ending inventory was $4,000,000. During the current year, Donny reported cost of goods sold on its income statement of $1,000,000. Exampleĭonny’s Furniture Company sells industrial furniture for office buildings. For instance, the apparel industry will have higher turns than the exotic car industry. Banks want to know that this inventory will be easy to sell. This measurement shows how easily a company can turn its inventory into cash.Ĭreditors are particularly interested in this because inventory is often put up as collateral for loans. If this inventory can’t be sold, it is worthless to the company. Inventory is one of the biggest assets a retailer reports on its balance sheet. This measurement also shows investors how liquid a company’s inventory is. It also shows that the company can effectively sell the inventory it buys. This shows the company does not overspend by buying too much inventory and wastes resources by storing non-salable inventory. Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is important to have a high turn. The cost of goods sold is reported on the income statement. Average inventory is usually calculated by adding the beginning and ending inventory and dividing by two. By December almost the entire inventory is sold and the ending balance does not accurately reflect the company’s actual inventory during the year. For instance, a company might purchase a large quantity of merchandise January 1 and sell that for the rest of the year. The inventory turnover ratio is calculated by dividing the cost of goods sold for a period by the average inventory for that period.Īverage inventory is used instead of ending inventory because many companies’ merchandise fluctuates greatly throughout the year. That’s why the purchasing and sales departments must be in tune with each other.

Sales have to match inventory purchases otherwise the inventory will not turn effectively. If the company can’t sell these greater amounts of inventory, it will incur storage costs and other holding costs. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of inventory to improve its turnover. This ratio is important because total turnover depends on two main components of performance. A company with $1,000 of average inventory and sales of $10,000 effectively sold its 10 times over. In other words, it measures how many times a company sold its total average inventory dollar amount during the year. This measures how many times average inventory is “turned” or sold during a period. The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing cost of goods sold with average inventory for a period.

Inventory turnover ratio formula and interpretation