Inventory turnover

Definition

Inventory turnover is a financial metric used to evaluate how efficiently a company manages its inventory. It measures the number of times a company’s inventory is sold and replaced over a specific period.

What is inventory turnover?

Inventory turnover is a key indicator of operational effectiveness, and the inventory turnover ratio is calculated using the following formula:

Inventory turnover = cost of goods sold (COGS) / average inventory 

A high inventory turnover ratio suggests that a company is efficiently managing its inventory. This can lead to reduced holding costs, lower risk of obsolete goods, and increased cash flow.

Efficient inventory turnover contributes to effective working capital management. It allows companies to free up capital that would otherwise be tied up in inventory.

While high inventory turnover is generally positive, it’s important to balance it with maintaining adequate product availability for customers. Overly aggressive inventory management can lead to stockouts, potentially impacting sales and customer satisfaction.

A low inventory turnover ratio may indicate that a company is holding excess inventory, which can lead to increased holding costs and a higher risk of obsolescence.

Monitoring changes in inventory turnover over time can provide valuable insights into a company’s performance and its ability to adapt to shifting market conditions.

Example of inventory turnover

XYZ Clothing Store is a retail business specialising in apparel. At the beginning of the year, the store had an inventory value of $200,000.

Throughout the year, XYZ Clothing Store made additional inventory purchases amounting to $500,000. During the same period, the store successfully sold clothing with a total sales revenue of $700,000. Let’s say the ending inventory is $50,000.

Then the inventory turnover ratio can be calculated as:

COGS = $500,000 – $50,000 = $450,000

Average inventory = ($200,000 + $50,000) / 2 = $125,000

Inventory turnover = $450,000 / $125,000 = 3.6

The calculated inventory turnover of 3.6 indicates that, on average, XYZ Clothing Store sold and replaced its inventory approximately 3.6 times during the year.