Inventory Turnover Ratio: How to Calculate Inventory Turnover

In a company's financial statements, the inventory turnover ratio is a metric that compares the cost of goods sold to the average value of inventory within an accounting period. The inventory turnover ratio formula is:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Value

The cost of goods sold (COGS) represents the expense of manufacturing a company’s products. COGS only includes direct costs like the price of the raw materials required to make the product and does not factor in indirect costs like those required to sell or market the product. The average inventory value represents the average cash value of the business's in-stock inventory in a given time period. An inventory turnover ratio can help business owners determine the number of times they turned, or sold out and replaced, their entire inventory in a given timeframe.

To calculate the cost of goods sold in a given period of time, add the value of the inventory you had at the beginning of the period to any purchases you made to make more inventory. Then subtract the value of the inventory at the end of that period from the total. The COGS formula is:

COGS = Beginning Inventory + Purchases – Ending Inventory

For example, if a sweatshirt company has $15,000 worth of inventory at the beginning of the quarter, spends $30,000 to make more sweatshirts throughout the quarter, and has $5,000 worth of sweatshirts left over at the end of the quarter, the COGS for that quarter would be $40,000.

To calculate your average inventory value, add the beginning inventory value to the ending inventory value and divide by two. The average inventory value formula is:

Average Inventory Value = (Beginning Inventory Value + Ending Inventory Value) / 2

For example, if the sweatshirt small business wanted to find its average inventory value for the quarter of the year, it would divide the sum of its beginning and ending inventory value ($20,000) by two to get a total of $10,000.

To continue with the sweatshirt business example, let’s imagine the business is calculating its inventory turnover ratio on a quarterly basis as well. They would take their COGS for that quarter ($40,000), divide it by the average inventory value for that quarter ($10,000), and get an inventory turnover ratio of four.

Manufacturers and retailers use inventory turnover ratios for various forms of forecasting.

• Sales forecasting: With good data, inventory management software can predict the number of days it will take before a company sells its stock on hand. This is known as the days sales of inventory (DSI) calculation, or the average inventory value divided by COGS and multiplied by 365.
• Inventory management: If a business has a high inventory turnover rate, it may have to ramp up its orders for merchandise and raw materials from suppliers to meet consumer demand. If it has a low inventory turnover ratio, it may need to scale back its inventory balance to avoid overstocking and the high storage costs associated with overstocking.
• Cash flow: An inventory turnover ratio can help businesses project cash flow on a balance sheet. When inventory turns over at a reliable rate, a business can estimate its upcoming cash on hand.
• Pricing strategy: If a company is flooded with excess inventory, it may need to lower its prices to produce a higher inventory turnover ratio. An excessive amount of inventory can be costly due to depreciation and obsolescence.

Although it is most common to calculate an inventory turnover ratio on a monthly or quarterly basis, modern accounting software makes it simple to find the inventory turnover ratio for any period of time.

A quick glance at a company's inventory turnover ratio can tell you something about its stock turnover and supply chain.

• High inventory turnover ratio: A high inventory turnover ratio means the company quickly churns through its in-stock inventory. It relies on a healthy supply chain to keep goods flowing into its stores and warehouses.
• Low inventory turnover ratio: A low inventory turnover ratio means that a business holds on to merchandise for relatively long periods of time. An extremely low inventory turnover rate can signal a need for inventory control since unsold merchandise can depreciate over time.

An inventory turnover ratio cannot necessarily foretell profitability. Some industries, such as luxury jewelry and designer furniture, have naturally long turnover times and low benchmark ratios compared to other industries. However, these industries operate at high profit margins, so they may be just as financially healthy as a chain of grocery stores with a lighting-fast inventory turnover rate.

Get the MasterClass Annual Membership for exclusive access to video lessons taught by business luminaries, including Sara Blakely, Chris Voss, Robin Roberts, Bob Iger, Howard Schultz, Anna Wintour, and more.