Definition: Inventory turnover, often called merchandise turnover, is a efficiency ratio that calculates the number of times average inventory is sold during a period. In other words, it measures how often a company can sell its average inventory.
What Does Inventory Turnover Mean?
The inventory turnover ratio is calculated by dividing cost of goods sold by the average inventory for the period. Since most companies don’t actually compute an average inventory number of a regular basis, you can compute the average of the accounting period by adding the beginning and ending totals and dividing by two.
Managers, investors, and creditors use this ratio to measure how well a company is a purchasing and selling its products. A lower ratio shows that either management is purchasing more merchandise than it can sell or that it is having trouble creating sales. Either way, a low turnover ratio indicates that the company is having problems.
Example
Managers are concerned with both indications. They want to make sure they don’t purchase too much merchandise because idle inventory reduces cash flow. They also want to make sure that the current products are actually selling that they stock what customers want. This is kind of a double-sided problem for the company. On one hand, they don’t want to spend too much cash on inventory. On the other hand, they need enough to keep customer happy.
Investors look at this ratio to estimate how well the company is performing in sales. A higher turnover ratio shows investors that the company is using a smaller amount of merchandise to generate a large amount of sales. A higher ratio will ultimately generate profits.
Creditors simply want to make sure they will be repaid. They tend to look at inventory turnover to see if companies are draining their cash flow by investing too heavily in inventory.
