The Inventory Turnover Ratio (ITR) is a metric that measures a company’s efficiency in managing inventory. The ratio shows how many times a company has sold or replaced its inventory within a year.

In simpler terms, a higher inventory turnover ratio means a company is effectively converting inventory into revenue. On the other hand, a low ratio indicates that stock is not moving as quickly and may be sitting on shelves or in storage for too long.

However, extremely high inventory turnover can also create challenges for hyper-growth companies. Reordering too often can cause financial constraints and capital demands, scaling problems, and storage issues.

Therefore, a business needs to have a good handle on inventory management. Inventory requires capital and can significantly affect a company’s growth. Effective management often optimizes a company’s inventory turnover as it is one of the critical components of managing cash flow.

I pay close attention to the ITR for all companies handling physical goods. Whether it is a fashion retailer, grocery store, car manufacturer or electronic goods distributor. There have been instances when studying the Inventory turn revealing that a competitor was actually a far better operator.

For example, when investigating a rapidly growing furniture franchise in Southeast Asia, comparing the Inventory turnover to another peer revealed the competitor was a better canditate. It was moving its products faster and managing its capital more effectively.

If inventory is not moving it means revenue is not coming in.

What is the Inventory Turnover formula?

• Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
• Cost of Goods Sold = Found on the Income Statement
• Average Inventory = Found on the Balance Sheet

Cost of Goods Sold (COGS) is the direct cost of producing goods (including raw materials) to be sold by the company.

Average Inventory is calculated by identifying the beginning and ending Inventory balances which are found on the company’s balance sheet. Once you have them divide them by 2 which gives you the average. Average inventory creates a more stable and reliable measure as it irons out lumpy numbers.

Days Sales of Inventory (DSI)

There is a second component to the ITR and that is the day sales of Inventory. This reveals the average number of days it takes to turn inventory on hand into sales (or to offload inventory entirely). I always use them both together. The formula is below and uses the same denominators however reverses them and breaks them into days.

How to use the Inventory Turnover Ratio?

The inventory turn is a useful tool for investors to gauge how quickly a business is converting products into revenue. Analysing inventory management can also help understand the capital cycle, and growth prospects, and even forecast a company’s potential.

However, the inventory turnover is only useful when comparing companies within the same industry. Different industries have vastly different turnover ratios, and it’s not fair to compare a high-end luxury brand to a discount retailer in fast-moving consumer goods. Similarly, you cannot compare the turnover of jet engines to that of beverages. Business models matter when comparing inventory turnover.

Let’s take a look at three companies all in the same industry and evaluate the potential meaning behind the numbers.

	Company A	Company B	Company C
Cost of Goods Sold	$2.8 billion	$3.25 billion	$5.77 billion
Average Inventory	$487 million	$981 million	$469 million
Inventory Turn	5.74x	3.31x	12.30x

So, here we have our three companies and the ITR metrics. Before we begin to understand each of the numbers let’s work out the Days Sales component also for each company to help our assesment.

A 365 ÷ 5.74 = 63 Days to turnover Inventory.

B 365 ÷ 3.31 = 110 Days to turnover Inventory.

C 365 ÷ 12.30 = 29 Days to turnover Inventory.

Based on the numbers, Company C is the front runner out of the three companies. This is because Company C can turn over inventory much faster than the other two companies, resulting in more revenue, improved cash flow, and profitability. On the other hand, Company B has a lower turnover rate, averaging 110 days.

The high turnover rate of Company C suggests they may be spending less on inventory purchases and incurring lower storage and holding costs compared to its peers.

In Summary…

When conducting fundamental analysis, a clear advantage like a higher turnover rate is what investors should look for. This is because a higher turnover rate has a positive impact on fixed costs, resulting in lower costs to manage inventory, warehousing, and labor, ultimately leading to improved cash flow.

While a higher inventory turnover ratio is desirable, investors should also ensure that the company has enough inventory in stock and is replenishing it often. It is important to note that an excessively high inventory turnover rate could be due to significant discounting, which would affect Gross Margins.

A lower inventory ratio could mean that a company is overstocked, which can impact holding costs, especially if the products become obsolete. Additionally, a low turnover rate could indicate poor sales or poor inventory management, which could be a red flag for investors regarding issues within a business’s operation.

Efficient inventory management is crucial for businesses to stay competitive. Shorter production lead times and localized supply chains can help create a competitive advantage. Optimized inventory management ensures maximizing sales without wasting capital or taking on too much risk. This ratio helps businesses make informed decisions regarding pricing, production, and marketing.

When conducting research, it is important to ask questions about the pricing strategy of the company, the level of demand for their products, and which products are selling or not selling.

By analysing the inventory churn of a company, you can gather valuable insights into how the business functions and generates revenue.

When I’m considering the turnover ratio, a range of 5 to 10 is generally considered good, particularly for growing companies. This indicates that the company can sell and restock its inventory every couple of months, which is a good balance.