This activity measure shows how efficiently the company is handling inventory management and replenishment and how fast the products are being sold. The less inventory a company keeps on-hand, the lower its costs are to store and hold it. This strategy lowers the cost of inventory that must be financed with debt or owners’ equity, or the ownership rights left over after deducting liabilities.
To compute this ratio, divide the cost of goods sold by average inventory. Suppose that the cost of goods sold is$35,000 and average inventory is $8,500. Inventory turnover is 4.12 times($35,000 / $8,500). Again, comparing this inventory turnover figure against industry averages, the higher the ratio, the better.
The turnover ratio shows how efficiently goods are sold by calculating the number of times that the inventory is sold and replaced in a given time period. A lower ratio indicates poor sales and excessive inventory which can show problems with pricing policy. A higher ratio indicates a too narrow selection of goods and may indicates lost sales.
The industries that tend to have the most inventory turnover are those with high volume and low margins, such as retail, grocery and clothing stores.
In industries such as the grocery store industry, it is normal to have very high inventory turnover. According to CSIMarket, the grocery store industry had an average inventory turnover of 18.56, which means the average grocery store replenishes its entire inventory close to 19 times a year. This high inventory turnover is largely due to the fact that low-margin industries such as the grocery store industry need to offset lower per-unit profits with higher unit sales volume. These types of industries have proportionately higher sales than inventory costs for the year.
In addition to high volume and low margin industries needing a higher inventory turnover to remain cash-flow positive, a high inventory turnover can also signal an industry as a whole is enjoying strong sales or has very efficient operations. It is also a signal the industry is less risky since the industry as a whole can replenish its cash quickly and is not stuck with inventory that can become obsolete or outdated.