Inventory turnover measures how productively a company uses its merchandise inventory to generate sales and profits.
Calculating inventory turnover
Here is the formula for inventory turnover:
Inventory turnover = Cost of goods sold⁄Average inventory
Cost of goods sold measures the amount paid to purchase or manufacture items that were sold during the period. To find cost of goods sold, look to the second or third line item in the company’s income statement (or statement of operations). It is sometimes referred to as cost of sales.
To compute average inventory, divide the sum of beginning inventory and ending inventory by two:
Average inventory = (beginning inventory + ending inventory) / 2
Beginning inventory is the value of inventory at the end of last year. It is listed in the balance sheet under current assets. Identify the balance of inventory not at the end of the current year, but rather at the end of last year – it is usually found in the last column on the right. Note that inventory is sometimes referred to as merchandise inventory.
Ending inventory is the value of inventory at the end of this year. It appears on the balance sheet under current assets, the second-to-last column on the right.
Technical note: a more accurate way to calculate average inventory is to add inventory at the beginning of the first quarter to inventory at the end of each quarter during the year. Then divide by five.
In 2016, Macy’s had cost of goods sold of $16,496. The company’s beginning inventory in 2016 was $5,417. Its ending inventory was $5,506.
Average inventory = ($5,417 + $5,506) / 2 = $5,462
Inventory turnover = $16,496 / $5,462 = 3.02
Interpreting inventory turnover
Successful businesses rely on using their merchandise inventory to generate sales and profits. After all, merchandise inventory is an investment, like any other asset. It needs to generate profits. Too much inventory requires a greater investment – and maybe even more debt – and can result in unsold, obsolete, or spoiled goods. Stocking too little inventory can cause you to lose sales. After all, customers who can’t find what they’re looking for will shop elsewhere.
Inventory turnover describes how many times, on average, inventory “turns over” each year. Visualize a shelf with widgets. If the widgets have turnover of 4.0, that means that on average the company will stock and then sell all of its widgets four times a year. Higher turnover indicates that the company’s inventory is purchased and sold relatively quickly. It’s flying off the shelves. Lower turnover indicates that it takes a longer time for the company to sell its inventory.
Macy’s inventory turnover is 3.02. Wal-Mart’s inventory turnover for the same period was 8.06. Wal-Mart’s higher inventory turnover indicates that the company sells its inventory more than twice as quickly as Macy’s.
Number of days’ inventory
Number of day’s inventory provides the same basic information as inventory, but in an easier-to-interpret figure. It indicates how many days – on average – it takes a company to sell inventory. Here’s the formula:
Number of days’ inventory = 365 / inventory turnover
For simplicity sake, some people may use the number 360 in the numerator instead of 365.
As I note above, Macy’s inventory turnover is 3.02. The company’s number of days’ inventory equals 365 / 3.02 = 120.9. This means that on average it takes about 121 days from when Macy buys inventory and when it sells it. On the other hand, Wal-Mart’s inventory turnover is 8.06. Its number of day’s inventory equals 365 / 8.06 = 45.3. On average, only 45 days pass between when the company first buys inventory and when it sells it. Clearly, Wal-Mart makes more productive use of its inventory investment than Macy’s. Visualize inventory flying off the shelves of a Wal-Mart store, while it sits in the racks at Macy’s, waiting to be purchased.
Lesson for entrepreneurs
Use inventory turnover or number of days’ inventory to keep your inventory levels productive. Monitoring these ratios will help to ensure that you’re not stocking too much or too little inventory.