Inventory Turnover
What is 'Inventory Turnover'
Inventory turnover is a ratio showing how many times a company's inventory is sold and replaced over a period of time. The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand. It is calculated as sales divided by average inventory.BREAKING DOWN 'Inventory Turnover'
Inventory turnover measures how fast a company is selling inventory and is generally compared against industry averages. A low turnover implies weak sales and, therefore, excess inventory. A high ratio implies either strong sales and/or large discounts.The speed with which a company can sell inventory is a critical measure of business performance. It is also one component of the calculation for return on assets (ROA); the other component is profitability. The return a company makes on its assets is a function of how fast it sells inventory at a profit. As such, high turnover means nothing unless the company is making a profit on each sale.Inventory Turnover Example
Inventory turnover is calculated as sales divided by average inventory. Average inventory is calculated as: (beginning inventory + ending inventory)/2. Using average inventory accounts for any seasonality effects on the ratio. Inventory turnover is also calculated using the cost of goods sold (COGS), which is the total cost of inventory. Analysts divide COGS by average inventory instead of sales for greater accuracy in the calculation of inventory turnover. This is because sales include a markup over cost. Dividing sales by average inventory inflates inventory turnover.Approach 1: Sales Divided By Average Inventory
As an example, assume company A has $1 million in sales. The COGS is only $250,000. The average inventory is $25,000. Using the first equation, the company has inventory turnover of $1 million divided by $25,000, or 40. Translate this into days by dividing 365 by inventory days. The answer is 9.125 days. This means under the first approach, inventory turns 40 times a year, and is on hand approximately nine days.Approach 2: COGS Divided By Average Inventory
Using the second approach, inventory turnover is calculated as the cost of goods sold divided by average inventory, which in this example is $250,000 divided by $25,000, or 10. The number of inventory days is calculated by dividing 365 by 10, which is 36.5. Using the second approach, inventory turns over 10 times a year and is on hand for approximately 36 days.The second approach gives a more accurate measure, as it does not include a markup. Only compare inventory turnover that uses the same approach for an apples-to-apples comparison.
For more details, check out "How do I calculate the inventory turnover ratio?"
Days Sales Of Inventory - DSI
What is 'Days Sales Of Inventory - DSI'
The days sales of inventory value, or DSI, is a financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its inventory (including goods that are a work in progress, if applicable) into sales. Generally, a lower (shorter) DSI is preferred, but it is important to note that the average DSI varies from one industry to another.Here is how the DSI is calculated:
The term days sales of inventory is also referred to as days inventory outstanding (DIO), days in inventory (DII) or, simply, days inventory.
BREAKING DOWN 'Days Sales Of Inventory - DSI'
Days sales of inventory, or days inventory, is one part of the cash conversion cycle, which represents the process of turning raw materials into cash. The days sales of inventory is the first stage in that process. The other two stages are days sales outstanding and days payable outstanding. The first measures how long it takes a company to receive payment on accounts receivable, while the second measures how long it takes a company to pay off its accounts payable.To learn more about the cash conversion cycle, see Understanding the Cash Conversion Cycle.
DSI is one measure of inventory effectiveness. By calculating the number of days that a company holds onto inventory before selling, the efficiency ratio measures the average length of time that a company’s cash is tied up in inventory. The calculation gives further perspective to the overall inventory ratio by putting the figure into a daily context. The formula for DSI, equivalent to the average days to sell the inventory, is calculated as follows:
(Inventory / Cost of Sales) * 365
This metric taken on its own, however, lacks context. DSI tends to
vary greatly between industries, depending on product type, business
model, etc. Therefore, it is important to compare the value to that of
other similar companies. For example, businesses that sell perishable or
fast-moving products such as food items will have a lower DSI than
those that sell non-perishable or slow-moving products such as cars or
furniture.As an example of the application of these important metrics, take Wal-Mart Stores, Inc. (WMT), which in 2014 reported annual sales of approximately $476 billion. Its year-end inventory equaled $44.9 billion, while its annual cost of sales was $358.1 billion. Thus, Wal-Mart’s inventory turnover for the year would be calculated as such:
$358.1 billion / $44.9 billion = 8
And the global retail giant’s DSI would be calculated accordingly,
indicating that Wal-Mart sells its entire inventory within a quick
46-day period:
(1 / 8) * 365 = 46
Inventory Turnover
The term inventory turnover refers to the number of times that inventory is sold or used over the course of a particular time period such as a quarter or year. A crucial metric for businesses, especially retailers of physical goods, the inventory turnover ratio measures a company’s efficiency in terms of management, inventory and generation of sales. As with a typical turnover ratio, inventory turnover calculates the amount of inventory that is sold over a period of time. As detailed in the Wal-Mart example, the formula for the inventory turnover ratio is as follows:
Cost of Goods Sold / Average Inventory
or
Sales / Inventory
In general, the higher inventory turnover ratio, the better it is for
the company, as it indicates a greater generation of sales. In the same
vein, a smaller inventory and the same amount of sales will also result
in a high inventory turnover. In some cases, if the demand for a
product outweighs the inventory on hand, a company will see a loss in
sales despite the high turnover ratio, thus confirming the importance of
contextualizing these figures by comparing them against those of
industry competitors.To learn more about the inventory turnover ratio, read the following FAQ: How Do I Calculate the Inventory Turnover Ratio? For more information on efficiency metrics, see the article on Measuring Company Efficiency.
Why It Matters
Metrics such as inventory ratio and days sales of inventory, specifically, can help inform investment decisions as they can indicate to an investor whether a company can effectively manage its inventory when compared to competitors. A 2013 study published on the Social Science Research Network and entitled Does Inventory Productivity Predict Future Stock Returns? A Retailing Industry Perspective suggests that stocks in companies with high inventory ratios tend to outperform industry averages. Such a stock that brings in a higher gross margin than predicted, can give investors an edge over competitors due to the potential surprise factor. Conversely, a low inventory ratio may suggest overstocking, market or product deficiencies or otherwise poorly managed inventory–signs that generally do not bode well for a company’s overall productivity and performance.While these correlations seem intuitive, it is important to note possible exceptions. In some cases, a low inventory ratio may be preferred, for instance if inventory is increased in anticipation of a market shortage or a rapid price increase. If inventory is selling slowly, then a surplus is certainly not desirable. On the other hand, a shortage of inventory can lead to a higher ratio of turnover, though the company may experience a loss in sales. This is to say that it is important to find a mutually beneficial balance between optimal inventory levels and market demand.
For more information on the importance of inventory turnover and days sales of inventory, read the article What Does a High Inventory Turnover Tell Investors About a Company?
In summation, managing inventory levels is vital for most businesses, and it is especially important for retail companies or those selling physical goods. While the inventory turnover ratio is one of the best indicators of a company’s level of efficiency at turning over its inventory and generating sales from that inventory, the days sales of inventory ratio goes a step further by putting that figure into a daily context, and providing a more accurate picture of the company’s inventory management and overall efficiency.
Average Age Of Inventory
What is 'Average Age Of Inventory'
The average age of inventory is the average number of days it takes for a firm to sell off inventory. The formula to calculate the average age of inventory is C/G x 365, where C is the average cost of inventory at its present level, and G is the cost of goods sold (COGS).BREAKING DOWN 'Average Age Of Inventory'
Also referred to as days' sales in inventory (DSI), the average age of inventory is a metric that analysts use to determine the efficiency of sales. It tells the analyst how fast inventory is turning over at one company compared to another. The faster a company can sell inventory for a profit, the more profitable it is. However, a company could employ a strategy of maintaining higher levels of inventory for discounts or long-term planning efforts. While the metric can be used as a measure of efficiency, it should be confirmed with other measures of efficiency, such as gross profit margin, before making any conclusions.Average Age of Inventory Example
An investor decides to compare two retail companies. Company A owns inventory valued at $100,000 and the COGS is $600,000. The average age of Company A's inventory is calculated by dividing the average cost of inventory by the COGS and then multiplying the product by 365 days. The calculation is $100,000 divided by $600,000, multiplied by 365 days. The average age of inventory for Company A is 60.8 days. That means it takes the firm approximately two months to sell a piece of inventory.Conversely, Company B also owns inventory valued at $100,000, but the cost of inventory sold is $1 million, which reduces the average age of inventory to 36.5 days. On the surface, Company B is more efficient than Company A.
Interpreting the Results
The average age of inventory is a critical figure in industries with rapid sales and product cycles, such as technology. A high average age of inventory can indicate that a firm is not properly managing its inventory or that it has inventory that is difficult to sell.The average age of inventory helps purchasing agents make buying decisions and managers make pricing decisions, such as discounting existing inventory to move product and increase cash flow. As a firm's average age of inventory increases, its exposure to obsolescence risk also grows. Obsolescence risk is the risk that the value of inventory loses its value over time or in a soft market. If a firm is unable to move inventory, it can take an inventory write-off for some amount less than the stated value on a firm's balance sheet.
Average Inventory
What is 'Average Inventory'
Average inventory is a calculation comparing the value or number of a particular good or set of goods during two or more specified time periods. Average inventory is the mean value of an inventory throughout a certain time period, which may vary from the median value of the same data set. A basic calculation for average inventory is:(Current Inventory + Previous Inventory) / 2
!--break--Since two points do not always accurately represent changes in inventory over different time periods, average inventory is frequently calculated by using the number of points needed to more accurately reflect activities across a certain amount of time.
For instance, if a business was attempting to calculate the average inventory over the course of a fiscal year, it may be more accurate to use the inventory count from the end of each month, including the base month. The values associated with each point are added together and divided by the number of points, in this case 13, to determine the average inventory.
For example, when calculating a three-month inventory average, the business achieves the average by adding the current inventory of $10,000 to the previous three months of inventory, recorded as $9,000, $8,500 and $12,000, and dividing it by the number of data points, as follows:
($10,000 + $9,000 + $8,500 + $12,000) / 4
This results in an average inventory of $9,875 over the time period being examined.
Average Inventory Analysis
The average inventory figures can be used as a point of comparison when looking at overall sales volume. This allows a business to track inventory losses that may have occurred due to theft or shrinkage, or due to damaged goods caused by mishandling. It also accounts for any perishable inventory that has expired.Moving Average Inventory
A company may choose to use a moving average inventory when it's possible to maintain a perpetual inventory tracking system. This allows the business to adjust the values of the inventory items based on information from the last purchase. Effectively, this helps compare inventory averages across multiple time periods by converting all pricing to the current market standard. This makes it similar to adjusting historical data based on the rate of inflation for more stable market items. It allows simpler comparisons on items that experience high levels of volatility.To learn more about average inventory, read Why is it sometimes better to use an average inventory figure when calculating the inventory turnover ratio?
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