What it means
The ratio is calculated from cost of goods sold divided by average inventory, both taken at cost so the two sides are measured on the same basis. Using sales revenue in the numerator inflates the answer, because revenue includes gross margin that inventory at cost does not.
Average inventory usually means opening plus closing divided by two, though a monthly average is far more reliable for a seasonal business. A retailer whose year ends in a quiet January can otherwise show a flattering figure that says nothing about the rest of the year.
The result is often converted into days by dividing 365 by the turnover figure. Most people find days of inventory easier to picture, and it can be added directly to debtor days and subtracted from creditor days to give the cash conversion cycle.
What counts as good varies enormously by sector, so the number only means something in context. A supermarket may turn stock more than twenty times a year while a jeweller or a machinery dealer may turn it twice, and neither figure is wrong for its industry.
A rising figure is not automatically good news either. Turnover climbs when stock is cut too far and the business starts running out, so the ratio should always be read alongside availability, lost sales and gross margin.
In practice
Real-world examples.
Example
A convenience store chain reports inventory turnover of 22 times, or about 17 days of stock. Its buyers watch the figure weekly because most of the range is perishable and a slowdown quickly turns into waste.
Example
An industrial valve distributor turns stock 2.5 times a year, equal to 146 days. That looks alarming next to a retailer, but customers pay a premium precisely because the distributor holds parts nobody else stocks.
Example
A clothing brand's turnover jumps from 4 to 6 times after a poor season. Management celebrates until the review shows the rise came from clearing stock at heavy discounts, which cut gross margin by four percentage points.
Formula
Calculation
Inventory turnover = cost of goods sold / average inventory
Average inventory = (opening inventory + closing inventory) / 2
Days of inventory = 365 / inventory turnover
A wholesaler reports cost of goods sold of $7,200,000 for the year. It opened with inventory of $1,100,000 and closed with $1,300,000, so average inventory is ($1,100,000 + $1,300,000) / 2 = $1,200,000.
Inventory turnover is $7,200,000 / $1,200,000 = 6.0 times, and days of inventory are 365 / 6.0 = 60.8 days, or roughly two months of stock on hand.
If the same business reduced average inventory to $900,000 without losing sales, turnover would rise to $7,200,000 / $900,000 = 8.0 times and days of inventory would fall to 365 / 8.0 = 45.6 days. That improvement would release $1,200,000 - $900,000 = $300,000 of cash permanently, and at a 9% cost of borrowing it would also save $300,000 x 0.09 = $27,000 a year in interest.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Quillon Electricals, an invented wholesaler of lighting and cable, had cost of goods sold of $18,000,000 and average inventory of $3,000,000, giving turnover of $18,000,000 / $3,000,000 = 6.0 times and 365 / 6.0 = 60.8 days of stock. Its bank pointed out that comparable wholesalers were running closer to eight turns.
The fictional management team spent a year attacking the slow end of the range rather than the whole warehouse. They cut roughly 900 lines that between them generated almost no gross profit, negotiated consignment terms on two large cable ranges, and moved to weekly rather than monthly reordering on the fastest 200 items.
Average inventory came down to $2,250,000, lifting turnover to $18,000,000 / $2,250,000 = 8.0 times and cutting days of stock to 365 / 8.0 = 45.6 days. The $750,000 of cash released paid off the overdraft, saving $750,000 x 0.09 = $67,500 a year in interest, and because the cuts were aimed at dead lines rather than popular ones, service levels held steady.
Watch out
Common mistakes.
- Using sales revenue instead of cost of goods sold in the numerator, which overstates turnover by the gross margin and makes comparison with other businesses meaningless.
- Taking closing inventory alone rather than an average, which distorts the figure badly for any business with a seasonal pattern.
- Treating a higher figure as automatically better, when it can reflect stockouts and lost sales rather than genuinely tighter buying.
Questions
People also ask.
What is a good inventory turnover ratio?
It depends entirely on the industry, so the useful comparison is against similar businesses and against the same company's own trend rather than any universal number.
How does inventory turnover relate to the cash conversion cycle?
Days of inventory is one of its three components, added to days sales outstanding and reduced by days payable outstanding.
Can the ratio be calculated in units instead of dollars?
Yes, and for a single product line units can be clearer, but a company wide figure has to use values because different products cannot be added together meaningfully.
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