The inventory turnover ratio is a financial metric that measures how many times a company’s inventory is sold and replaced over a specific period.
Primary Implication
Typically, a high inventory turnover ratio indicates that inventory is sold at a faster rate and that fewer company resources are tied up in inventory.
If you move a lot of inventory and this is true for your business, then this is a critical ratio confirming the efficiency of your business operations.
If it’s low, it may represent a higher risk of loss through un-saleable inventory if you carry a lot of inventory.
The importance of this ratio is proportionate to the value of inventory you carry on your Balance Sheet. If it’s close to what you report for accounts receivable or it exceeds your accounts payable, then this is a key ratio for you to monitor.
Overview
Inventory Turnover Ratio (ITR) is an Efficiency Ratio that shows how easily a company can turn its inventory into cash through projected sales. If the inventory can’t be sold, it’s worthless to the company.
ITR depends on purchasing efficiency and sales velocity. Ideally, sales must match inventory purchases; otherwise, the inventory will not turn over efficiently.
High inventory turns mean better liquidity from superior merchandising, or, can also mean a shortage in needed inventory for sales. Low inventory turns mean poor liquidity, possible overstocking, obsolescence, or a planned inventory buildup. Zero is the best possible ITR ratio.
The formula for the Inventory Turnover Ratio is as follows:
COGS / Average Inventory
An inventory turnover ratio of 4 means that inventory was “turned over” or replenished four times during one year. This equates to inventory being turned over once every 91 days, or 365 days ÷ 4.
Higher is Better: normally, a high number indicates that inventory is sold at a faster rate and that fewer company resources are tied up in inventory.
Lower is Worse: represents a higher risk of loss through un-saleable inventory (see above.)
