The financial statements of any business entity give insights into any business entity’s financial health and performance. However, a business entity might need to perform further analysis to deeply evaluate the financial results.
Therefore, companies perform different financial analyses. The popular type of analysis is sensitivity analysis, vertical & horizontal analysis, ratio analysis, growth rates, leverage analysis, profitability analysis, etc.
Ratio Analysis is a broad method of quantitatively measuring the performance of any business entity in different areas. Ratio analysis provides a foundation for assessing profitability, liquidity, and operational efficiency.
The data from the balance sheet, income statement, and cash flow statement is used to calculate different ratios and interpret them to draw opinions.
Inventory is the most significant current asset of any business. Besides, it’s the fuel of any business, whether trading or manufacturing concern. The financial statement reports the inventory levels of an entity.
However, there is no information on how different inventory levels impact the overall performance of the business entity. That’s why ratio analysis is used to get useful insights about inventory.
This article will discuss the inventory turnover ratio and what factors affect the increase or decrease of the inventory turnover ratio for any business entity.
What Is Inventory Turnover Ratio?
The inventory turnover ratio is also known as the stock turnover ratio. It’s a significant ratio when it comes to the efficiency of inventory management and cost decisions about inventory levels. In simple terms, it can be defined as,
How many times does a company sell its inventory and replenish the stock over a specific amount of time?
The inventory turnover ratio is generally expressed as how many times a company succeeds in selling its stock and getting the new stock. Most commonly, the inventory turnover ratio is calculated on an annual basis. But it can also be measured on a monthly basis if the frequency of stock replenishment is very high.
The inventory turnover ratio is calculated by dividing the cost of goods sold over the average inventory during a specific period.
Companies calculate the inventory turnover ratio for effective inventory control or stock control so that the company is not bounding its funds excessively. It also ensures that the company is not suffering from the long lead times resulting in loss of sales.
Formula
The inventory turnover ratio is calculated using a mathematical equation. The formula is as follows:
Inventory Turnover ratio = Cost of Goods Sold(CoGS)/Average InventoryAverage inventory represents the average amount of inventory over two or more accounting periods. It is calculated by taking the median value of the beginning and ending inventory. In general, the beginning and end period of inventory for calculation of inventory turnover ratio. The mathematical formula for average inventory will be as follow:
Average Inventory = (Beginning Inventory + Ending Inventory)/2Explanation & Example
The inventory turnover ratio requires the cost of goods sold and average inventory for its calculation. Therefore, it’s important to define the terms to better explain the inventory turnover ratio.
Cost of Goods Sold is defined as the cost of production of goods sold by a company during a specific period. It includes all the direct and indirect costs of labor, materials, and factory overhead. The trading businesses calculate the cost of goods sold by subtracting the ending inventory and adding the beginning Inventory to the purchases. The direct cost of transportation and excise are also added to purchases.
Average inventory, as already defined, is the mean value of the inventory value at two or more given times. In general, however, average inventory is calculated by taking the mean of the beginning and ending inventory during a specific period. If there is no beginning or ending inventory, the only available value is treated as average inventory.
Besides, some financial analysts also suggest using end-of-period inventory value for inventory turnover ratio calculation.
Let’s comprehend the inventory turnover ratio with the help of a practical example. We will compare the inventory turnover ratio for two business entities.
Walmart Inc.(WMT) and Target Corporation had the following financial figures for a financial year:
| Amount(in thousands | Walmart Inc. | Target |
| Inventory beginning | $44,469,000 | $8,601,000 |
| Inventory ending | $43,046,000 | $8,309,000 |
| Average Inventory | $43,757,000 | $8,455,000 |
| Cost of Goods Sold | $361,256,001 | $46,872,000 |
| Inventory Turnover Ratio | 8.26 | 5.54 |
Let’s look at the values of Walmart Inc. and Target Corporation. It’s clearly evident that Walmart is selling faster than Target. They’re replenishing their stock more frequently than Target.
The calculation for both the companies will be made as follows:
Walmart Inc.
Average Inventory = (Beginning Inventory + Ending Inventory)/2Average Inventory = ($44,469,000+ $43,046,000)/2
Average Inventory = $43,757,000
Inventory Turnover Ratio = $361,256,001/$43,757,000
Inventory Turnover Ratio = 8.26
Target
Average Inventory = (Beginning Inventory + Ending Inventory)/2Average Inventory = ($8,601,000+ $8,309,000)/2
Average Inventory = $8,455,000
Inventory Turnover Ratio = $46,872,000/$8,455,000
Inventory Turnover Ratio = 5.54
Reasons For Inventory Turnover Ratio Increase And Decrease
Now to the important question of what factors cause the inventory turnover ratio to increase or decrease. Here are some factors that play a significant role in how inventory turnover ratio increases or decrease.
Production
There are different manufacturing processes adopted by varying industries. Therefore, some of them result in higher inventory turnover. Whereas others result in lower inventory turnover.
If we talk about just-in-time manufacturing, the companies never have more than the required inventory on hand. They only restock the inventory when needed. As a result, the average inventory of the company will be lower.
When the denominator is a smaller number, the inventory turnover ratio will be higher. Therefore, if a company wants to improve its inventory turnover ratio and make it higher, shorter production runs can help.
Let’s talk about a decrease in inventory turnover ratio for the businesses. It relates to the manufacturing processes that require maintaining a large inventory stock. As a result, the denominator value increases, and we see a lower inventory turnover ratio.
Costs & Sales
Costs of sales are in the numerator when we calculate the inventory turnover ratio. If the company uses the cost control procedures, the cost of goods sold is brought to a lower level.
As a result, the profitability of the company is higher. If the companies use this strategy, the cost of goods sold is smaller, and as a result, the inventories are also kept lower at closing and the beginning of the year. Therefore, the inventory turnover ratio will be higher.
When the company goes for strategies to improve the profitability margin by sales growth, the turnover will be higher with lower inventory levels at opening and closing. When a company adopts the opposite practices or somehow, circumstances develop in such a way, the inventory turnover ratio will decrease.
Inventory
Inventory levels directly impact the increase or decrease in inventory turnover ratio. The lower inventory levels at the beginning and closing of a financial period signify a higher turnover ratio.
However, when a company overstocks inventory throughout the financial year or there are inefficiencies, the inventory turnover ratio will be lower.
How To Interpret Inventory Turnover Ratio?
It’s also important to understand the interpretation of the inventory turnover ratio. Without a clear understanding of interpretation, we can not conclude the best inventory turnover ratio.
In general, the stock turnover ratio tells us about the efficiency of the business. If the ratio is higher, it signifies better performance and vice versa.
When the company has a higher inventory turnover, it signifies lower holding and storage costs. Therefore, the overall cost is reduced, which directly relates to profitability.
When interpreting a company’s efficiency using the inventory turnover ratio, you should only compare business entities operating within the same industry. It’s because different industries have varying trends and stock requirements.
In general, a higher inventory turnover ratio is desirable for any business entity. It’s because overstocking or unsold inventory is exposed to the risk of market fluctuations, obsolescence, etc. Besides, the lower turnover ratio also indicates that the company’s sales team is not efficient in selling the stock.
Wrap Up
We have discussed everything you need to know about the inventory turnover ratio and how it impacts the financial outlook of a business entity. The factors affecting higher or lower inventory turnover are also discussed. Therefore, companies can work on these areas to improve their overall inventory turnover and business efficiency.
