Inventory turnover is a measure that determines how often a company sells and restores inventory. Expressed as a mathematical ratio, inventory turnover is an indicator of how efficiently a company manages inventory. Inventory turnover that declines is a negative sign that the company is not properly managing inventory.
The mathematical formula to calculate average inventory turnover can occur in two ways. The simplest way is to divide annual sales by annual inventory. A more complex and accurate measure is to calculate the annual cost of sales or cost of goods sold divided by the sum of beginning and ending inventory values divided by 2. High inventory turnover is the goal of a company, as it indicates that inventory management is efficient.
The time period for inventory turnover can be quarterly, semi-annual, annually or any period that the company decides to use as an inventory measure. For example, assume a company desires to measure inventory in the simple manner on an annual basis. Suppose the company had a starting inventory of $10,000 and quarterly sales of $20,000. The simple calculation of inventory turnover equals $20,000 in sales divided by inventory of $10,000 for a ratio of 2. To make the ratio make sense, divide 365 days in a year by the ratio of 2 for a value of 182.5. This means that inventory warehoused on average for 182.5 days out of the year.
Declining inventory turnover indicates such things as poor sales and inventory management, or out-of-date-inventory. It can also indicate that company management desires to keep a high inventory on hand, especially for companies that have surges in demand for products, but declining inventory turnover is generally a negative company indicator. Managing inventory properly is a critical risk factor for a company, since inefficient inventory management can create significant profit loss. A company does not want to turn inventory so frequently that the company runs out of product but in contrast, does not want inventory to stagnate.
Average inventory turnover ratios will vary by industry, and investors typically look to companies that have high turnover ratios. In order to accurately determine if an inventory ratio is high, low or declining, a person would research the inventory turnover average for the industry. As an example, on May 2, 2011 Wal-Mart has an inventory turnover ratio of 8.9, which is much higher than Sears Holding Corp.'s inventory turnover of 3.5. Sears is the holding company for Kmart, and the turnover ratio is a good indicator that Wal-Mart is moving inventory more efficiently.