What is Inventory turnover ratio?
As part of Financial Ratio analysis, Activity ratios predominantly indicate the efficiency of the company in managing its resources.
Inventory turnover ratio is one of the most important activity ratio that is more relevant in the case of manufacturing companies.
Similar to other activity ratios, even this ratio indicates how efficient is the company in generating revenue by utilizing its resources.
Inventory turnover ratio meaning
Inventory turnover ratio or stock turnover ratio basically indicates the number of times inventory was turned over or sold during a period (generally a year).
In a more simple sense, it shows how many times the stock of the company was sold during the year.
Let us look at the formula to understand the ratio better.
Inventory turnover ratio formula
The formula for inventory turnover ratio is quite similar to other turnover ratios.
We take the Cost of goods sold in the numerator and Average Inventory in the denominator.
COGS can be obtained from the Income Statement and Average Inventory can be obtained from the Balance Sheet of the company.
Below aspects need to be considered while calculating the numerator and denominator
Cost of Goods Sold / Cost of sales
- COGS refers to the cost that is incurred directly as part of the production process.
- Examples of COGS are Raw material cost, labor cost, and other direct expenses.
- Indirect expenses like Interest expense, Taxes, etc are not part of COGS.
Average Inventory
- Average inventory can be obtained from the Balance Sheet.
- We need to consider an average of closing inventory as at the current period-end and previous period-end.
To understand the formula better, let us consider few examples.
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Inventory turnover ratio example
Let us look at our 1st example.
We take Company A and Company B for calculating ITR.
The values given in the example below are in $ millions.
Consider the below-given income statement for both the companies.
To calculate Stock turnover ratio (ITR), we need
- Cost of Goods Sold
- Average Inventory
But first, let us calculate COGS for both the companies.
Company A
- Raw Material = $100
- Labour wages = $350
- Direct expenses $50
- COGS = $ 500
Company B
- Raw Material = $200
- Labour wages = $400
- Direct expenses $200
- COGS = $ 800
Now, to calculate the Average Inventory for both the companies, consider the below-given Balance Sheet.
In the above example, we are given only single period data.
Hence closing Inventory balance can only be considered as Average Inventory.
Average Inventory
- Company A = $ 123
- Company B = $ 123
Now that we know all the values, let us calculate the turnover ratio for both the companies.
Inventory Turnover ratio = COGS /Average Inventory
- Company A = $500/ $123 = 4x
- Company B = $800/ $123 = 6.5x
What this means is that Company A was able to turn the inventory 4 times during the year while Company B was able to turn 6.5 times.
ITR on a standalone basis, will not give any picture.
Hence, it has to be compared with the industry benchmark to make better conclusions.
Inventory turnover ratio for Walmart
Now, let us calculate the stock turnover ratio for Walmart using excel as part of the practical application of ratios.
You can download the Inventory turnover ratio template for Walmart using the below option.
Below shown is the Consolidated Income Statement of Walmart.
Cost of Goods Sold
In the case of Walmart, COGS can be easily calculated from the Income Statement.
COGS = $ 385,301
To calculate Average Inventory, consider below-given consolidated Balance Sheet for Walmart
Average Inventory
- Closing Inventory 2018 = $43,783
- Closing Inventory 2019 = $44,269
- Average Inventory = ($43,783 + $44,269) / 2
- Average Inventory = $44,026
Now that we know all the values, let us calculate the Stock turnover ratio for Walmart
Inventory Turnover ratio = COGS /Average Inventory
ITR = $385,301/ $44,026=8.8x
As evident, Walmart has a high inventory turnover ratio of 8.9 times.
What this means is that Walmart is able to turn its inventory almost 9 times during the year.
A better conclusion can be drawn only when the ratio is compared with other similar companies in the same sector.
Inventory turnover ratio interpretation
- As we have already understood, ITR indicates how many times the company was able to turn its inventory during a period.
- Generally, a high inventory turnover ratio indicates that the company is more efficient in managing its inventory as it is able to sell its inventory more frequently.
- Whereas, a low inventory turnover ratio shows that the company is unable to clear its stock from the warehouse.
- It indicates trouble either in demand for the products or marketing team’s inability to sell more goods.
- A low Stock turnover ratio leads to piling up of stock.
- This situation further leads to a low liquidity position since cash is blocked on these inventories which are taking large time to clear.
Trend Analysis
Any financial ratios will not give a clear picture when analyzed on a standalone basis.
Hence trend analysis has to be performed for a particular ratio.
This helps in understanding about the sustainability of the performance in the future.
Let us look at how the turnover ratio for Microsoft has moved historically.
As evident, ITR in the case of Microsoft has been increasing significantly.
Although not an inventory driven company, Microsoft was more efficient in managing its inventory.
The inventory turnover ratio increased gradually from 11x to the current 18x.
This increase indicates that the company was able to clear the inventory more frequently.
This, in turn, helped the company in increasing its overall liquidity position.
Comparison with similar companies
As mentioned earlier, to analyze any financial ratio better, a particular ratio should also be compared with other companies in the same sector.
Further, it is important to understand why the ratio is different from other non-similar sectors.
All such above exercise provides greater insight into the cross-sectional industry dynamics.
Walmart vs Amazon
In the case of Walmart (which runs a chain of hypermarkets, discount department stores,
and grocery stores), you can observe that the inventory turnover ratio is very low.
As required by the business model, companies like Walmart generally maintains a huge stock of inventory.
Compared to other companies, the Inventory turnover ratio for Walmart is at moderate 8 times.
Similarly, Amazon also needs to maintain a very high inventory as part of its business model.
Hence the inventory turnover ratio for Amazon is 8 times.
Both companies are not able to increase their ITR for the past 5 years.
Nonetheless, they are able to maintain a steady-state inventory turnover ratio of 8 times.
ExxonMobil
Exxon Mobil is a US-based multinational oil and gas company.
Generally, oil and gas companies are asset-heavy companies.
As part of their business model, they ideally maintain reserves of crude and similar other resources.
Since 2014, the average inventory for ExxonMobil has increased significantly.
This has lead to the fall in ITR. Hence, the inventory turnover ratio for ExxonMobil is 11x.
Microsoft
As already highlighted as part of trend analysis, Microsoft company was able to manage its inventory in a more efficient manner.
This has helped the company to increase its ITR from as low as 11x to 18x.
Important considerations
Below are few important aspects one must consider while analyzing any company using inventory turnover ratio
Manufacturing companies
As already highlighted, ITR is more relevant and useful for manufacturing companies than service-based companies.
Multiple Business verticals
At times company may have both manufacturing and service-based operations.
If the ratio is calculated using the company-wide COGS and Average Inventory, it will not give a true picture.
Hence, analysts generally calculate the ratio using segmental COGS and segmental average inventory. This helps in analyzing respective segments more clearly.
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