A company sells products to its costumers in hopes of turning a profit, this is business 101. However, what if the rate at which a company sells inventory gave analysts a better idea of future earnings? Inventory turnover is a good predictor a company’s success.
Inventory Turnover Measures Strength Of Sales
By definition, inventory turnover shows how many times a company sells inventory, then replaces it. Also, a few different ways of calculating this ratio exists. Some companies report inventory turnover in term of sales, while others use the cost of goods sold as their benchmark metric.
To determine average inventory, use this formula:
Average inventory = (beginning inventory + ending inventory) / 2
Furthermore, the aforementioned ratios are displayed below:
To determine inventory turnover in terms of net sales:
To determine inventory turnover in terms of cost of goods sold:
To determine how long it takes to ‘turnover’ (sell all of) inventory:
Companies never want excess inventory sitting on their shelves. This is potential profits that the company either reinvests or returns to shareholders. This measurement varies by industry, so you should always compare it to benchmark industry averages; not the overall market.
Analysts use inventory turnover to measure sales strength. Low inventory ratio leaves a company cash strapped and insolvent. Furthermore, this ratio relates to the company’s return on assets (ROA). Shareholders watch this ratio as it explains how efficiently a company utilizes its assets. Like other ratios, different industries scrutinize the measure with different importance. For example, a retail analyst shows great interest in the ratio, whereas a service company analyst values it less.
Finally, thanks to modern shipping practices, inventory turnover ratios are more important than ever. The rise of eCommerce created new challenges for retail businesses and place tremendous pressure on supply chains. Inventory management is becoming increasingly important in today’s fast-paced business landscape. Understanding supply-chain dynamics starts with learning how to utilize the inventory turnover ratio.
Larry D. is one of the most experienced writers at the Dork. His expert insights into the individual stocks have made small fortunes for some of his readers and profitable trades for many more. Best known for his work with under-the-radar growth stocks, Larry has been picking winners for over 30 years.
