Inventory Turnover
What Is Inventory Turnover?
Inventory turnover is a ratio that shows how many times a company’s inventory is sold or used over a period. It is also known as “inventory turnover” or “stock turnover”.
Inventory turnover measures the number of times a company sells and replaces its inventory during a given period.
A high inventory turnover indicates that a company is selling its inventory quickly and efficiently, while a low inventory turnover indicates that a company is not selling its inventory as quickly as it could be.
There are two ways to calculate inventory turnover:
-The first way is to divide the cost of goods sold (COGS) by the average inventory for the period. This method is often used by businesses that use FIFO (first in, first out) accounting.
-The second way is to divide the sales for the period by the average inventory for the period. This method is often used by businesses that use LIFO (last in, first out) accounting.
Inventory Turnover Ratio | Explained with Example
How to Interpret Inventory Turnover
There is no right or wrong answer when it comes to what is considered a good or bad inventory turnover ratio.
The ideal ratio depends on the industry in which a company operates.
For example, companies that operate in the retail industry generally have higher inventory turnover ratios than companies that operate in the manufacturing industry because retail companies sell their products much more quickly than manufacturing companies do.
That being said, there are some general guidelines that can be used to interpret inventory turnover ratios:
- A ratio of 1 means that a company has sold all of its inventory once during the period.
- A ratio of 2 means that a company has sold all of its inventory twice during the period.
- A ratio of 3 or higher is generally considered to be good, while a ratio of 2 or lower is generally considered to be one that could indicate some difficulty in turning over inventory.
What Is a Good Inventory Turnover Ratio?
As we mentioned earlier, there is no one answer to this question. The ideal inventory turnover ratio depends on the industry in which a company operates.
What Causes Inventory Turnover to Increase or Decrease?
There are a few different factors that can cause inventory turnover to increase or decrease:
Changes in the demand for a company’s products or services
An increase in the demand for a company’s products or services will generally lead to an increase in inventory turnover, while a decrease in the demand for a company’s products or services will generally lead to a decrease in inventory turnover.
Changes in the price of a company’s products or services
An increase in the price of a company’s products or services will generally lead to a decrease in inventory turnover due to lowered demand, while a decrease in the price of a company’s products or services will generally lead to an increase in inventory turnover due to increased demand.
Changes in the production process
An improvement in the production process will generally lead to an increase in inventory turnover, while a deterioration in the production process will generally lead to a decrease in inventory turnover.
Changes in the supply of raw materials
An increase in the supply of raw materials will generally lead to a decrease in inventory turnover (given raw materials and commodities often feed into finished goods that are sold), while a decrease in the supply of raw materials will generally lead to an increase in inventory turnover.
Which Industries Have the Highest Inventory Turnover?
The industries with the highest inventory turnover are generally those that have products with a short shelf life, such as food and beverage companies.
The industries with the lowest inventory turnover are generally those that have products with a long shelf life, such as furniture and appliance companies.
Inventory Turnover and the Cash Conversion Cycle
The cash conversion cycle is a measure of how long it takes a company to convert its raw materials, inventory, and other short-term assets into cash.
The cash conversion cycle has three components:
- Days inventory outstanding (DIO): This is the number of days that it takes a company to sell its inventory.
- Days sales outstanding (DSO): This is the number of days that it takes a company to collect payment from its customers.
- Days payables outstanding (DPO): This is the number of days that it takes a company to pay its suppliers.
A company’s inventory turnover ratio is directly related to its DSO and DPO.
A high inventory turnover ratio means that a company is selling its inventory quickly and, as a result, its DSO will be low.
A low inventory turnover ratio means that a company is selling its inventory slowly and, as a result, its DSO will be high.
A high inventory turnover ratio also usually means that a company is paying its suppliers quickly and, as a result, its DPO will be low.
A low inventory turnover ratio means that a company is paying its suppliers slowly and, as a result, its DPO will be high.
Summary – Inventory Turnover
Inventory turnover is a measure of how quickly a company sells its inventory. There is no one answer to the question of what is a good or bad inventory turnover ratio, as the ideal ratio depends on the industry in which a company operates.
However, there are some general guidelines that can be used to interpret inventory turnover ratios.
A ratio of 1 means that a company has sold all of its inventory once during the period, while a ratio of 2 or higher is generally considered to be good.
Factors that can cause inventory turnover to increase or decrease include changes in the demand for a company’s products or services, changes in the price of a company’s products or services, and changes in the production process.
The industries with the highest inventory turnover are generally those that have products with a short shelf life, while the industries with the lowest inventory turnover are generally those that have products with a long shelf life.
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