Maintaining inventory is a huge cost for many businesses, especially in the retail industry. The longer a product sits on store shelves, the more it deteriorates, and the greater the chances are that it will never get sold.
By contrast, the most-efficient businesses manage to keep minimal inventory levels, and sell the inventory they have quickly, replacing it with new products on a constant basis. One measure of a company's success in managing its inventory is in the metric known as inventory turnover. Below, we'll look at this measure, and what conclusions you can draw from it.
How to calculate inventory turnover
There are a couple of different ways you can look at inventory turnover, and while they'll give you similar results, they won't be exactly the same. One method involves taking the company's total sales, and then dividing it by the value of inventory listed on the balance sheet at the end of the period being measured. For instance, if a company sold $10 million during a year and had inventory worth $5 million, then its inventory-turnover ratio would be 2.0, or 200%.
However, some analysts believe that this measure of inventory turnover is misleading because it mixes two different valuation methods. Companies typically report their sales based on the market value that they received from customers buying their products, but they value their inventory based on their actual cost.
In order to compare apples to apples, an alternative takes the cost-of-goods-sold figure from the income statement and then divides it by the average-inventory figure during the period. That's typically derived from taking the reported inventory value at the beginning of the period and the end of the period, and using the midpoint as the divisor.
How to use inventory turnover in your analysis
As a measure in itself, inventory turnover has some value in analyzing a business. In general, a high inventory-turnover ratio means that the company is efficient at generating sales without having excessive levels of inventory on hand. Low inventory-turnover ratios suggest an inventory-heavy business model that can present financial challenges, including higher carrying expenses and shrinkage costs.
The better use of inventory turnover is in comparing businesses in the same industry. For instance, if one department-store retailer has an innovative way of managing inventory, its inventory-turnover ratio might be much higher than a competitor using less-advanced methods.
Managing inventory is a key part of many businesses. The inventory-turnover ratio gives you a way to evaluate progress over time and across players in an industry to see which companies are doing the best job in making the most of their inventory.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org . Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.