Inventory turnover analysis measure the liquidity of a firm’s inventory. It measures how many times the company turns over (sells, uses or replaces) its inventory during a period, such as the financial period.
It is calculated by dividing cost of goods sold by inventory. The formula is as follows.
Inventory Turnover = Cost of goods sold/Inventory
The results can be conveniently used to calculate the average age of inventory (also called average number of days sales in inventory or inventory turnover days) with the following formula:
Average age of inventory = 365/Inventory Turnover
Example of inventory turnover analysis
Assume Gold Co. has cost of goods sold of $1,850,000 and inventory of $680,000. Assume there are 365 days in the year. The inventory turnover analysis and average age of inventory analysis for the Gold Company is conducted as follows:
Inventory turnover analysis:
This indicates the business turns over its inventory 2.7 times per year.
Average age of inventory:
Things to note about inventory turnover analysis
The results are only meaningful when used in comparison. It can be compared to industry averages, to the firm’s past inventory ratios and to ratios of competitors.
Industry averages differ significantly between industries for this ratio. This ratio is positive (higher than zero) as long as the firm has any inventory. Generally, a high ratio is considered to be a good indicator.
However, the norm would differ significantly between industries. If the ratio is too high when compared to the norm within the industry, it may mean the company keeps too little inventory and, therefore, may lose some sales. On the other hand, a low ratio may indicate excess inventory and inferior sales. Excess inventory is usually considered to be undesirable as inventory is an investment without return, holding inventory implies costs and prices of goods to be sold may start decreasing.
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