Homework: Inventory Turnover

Inventory Turnover
 Definition

Inventory turnover is an efficiency ratio which calculates the number of times per period a
business sells and replaces its entire batch of inventories. It is the ratio of cost of goods sold by a
business during an accounting period to the average inventories of the business during the
period.

Dividing the total cost of inventories sold during a period (which equals cost of goods sold) by
the cost of average inventories balance maintained by a business gives us dollars of sales made
per dollar of cash tied up in inventories.

Inventory turnover ratio is calculated using the following formula:

Inventory Turnover = Cost of Goods Sold / Average Inventories

Cost of goods sold = Beginning Inventories + Cost of Goods Manufactured – Ending Inventories

Cost of goods sold figure is reported on the income statement.

 Where is it used?

Inventory turnover ratio is used to assess how efficiently a business is managing its inventories.

In general, a high inventory turnover indicates efficient operations. A low inventory turnover
compared to the industry average and competitors means poor inventories management. It may
be an indication of either a slow-down in demand or over-stocking of inventories. Overstocking
poses risk of obsolescence and results in increased inventory holding costs.

However, a very high value of this ratio may result in stock-out costs, i.e. when a business is not
able to meet sales demand due to non-availability of inventories.

Inventory turnover is a very industry-specific ratio. Businesses which trade perishable goods
have very higher turnover compared to those dealing in durables. Hence a comparison would
only be fair if made between businesses in the same industry. It is very useful in conducting a
trend analysis.

Average Inventory
  Definition

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 median value of an
inventory throughout a certain time period. A basic calculation for average inventory would be:

(Current Inventory + Previous Inventory) / 2

 Where is it used?

Average inventory is useful for comparison to revenues. Since revenues are typically presented
in the income statement not only for the most recent month, but also for the year-to-date, it is
useful to also calculate the average inventory for the year-to-date, and then match the average
inventory balance to year-to-date revenues, to see how much inventory investment was needed
to support a given level of sales.

Example 1: Calculate inventory turnover and days inventories outstanding for ABC, Inc. based on the
information given below:

Opening inventories $25,000

Closing inventories $30,000
Cost of goods manufactured $245,000

Solution

Cost of goods sold = $25,000 + $245,000 – $30,000 = $240,000

Average inventories = ($25,000 + $30,000) ÷ 2 = $25,500

Inventory turnover ratio = $240,000 ÷ $27,500 = 8.73

Days inventories outstanding = 365 ÷ 8.73 = 41.8

Example 2: Analyze the inventories turnover ratio for Wal-Mart Stores Inc. (NYSE: WMT), Costco
Wholesale Corporation (NASDAQ: COST), Caterpillar Inc. (NYSE: CAT) and Deere & Company (NYSE: DE)
based on their inventory turnover ratio (as obtained from Morningstar) for the financial year 2012, 2013
and 2014.

2012 2013 2014

Walmart 8.34 8.08 8.11
Costco 12.64 12.27 12.04
 Caterpillar 3.13 2.89 3.2
Deere & Co. 5.27 5.08 5.42

Solution

This example illustrates the fact that ratio analysis is useful when companies’ ratios are compared with
other firms in the same industry or across different periods for a single company.

Inventory turnover ratio of Walmart is comparable with Costco but not with Caterpillar or Deere.
Walmart & Costco are retailers of general merchandise while Caterpillar & Deere are manufacturers of
heavy machinery. Retailers are required to hold very large volume of inventories, a major portion of
which is perishable, which justifies their higher inventory turnover ratio as compared to manufacturers
of heavy machinery.

Walmart has been more efficient in its inventories management than Costco. However, Costco’s trend
of improvement over the three-year period is more pronounced.

Caterpillar is better than Deere & Co. in inventories management as evident from their inventory
turnover ratio. However, their relative trend in inventory turnover ratio corresponds with each other.
Inventory turnover ratio for both decreased in 2013 and then increased again in 2014. Such trends are
attributable to the overall economic growth expectations.

Example 3: Donny's Furniture Company sells industrial furniture for office buildings. During the current
year, Donny reported cost of goods sold on its income statement of $1,000,000. Donny's beginning
inventory was $3,000,000 and its ending inventory was $4,000,000.

Solution

Donny's turnover is calculated like this:

Inventory turnover Ratio: .29 times = 1,000,000 / [ (3,000,000 + 4,000,000) / 2 ]

As you can see, Donny's turnover is .29. This means that Donny only sold roughly a third of its inventory
during the year. It also implies that it would take Donny approximately 3 years to sell his entire
inventory or complete one turn. In other words, Danny does not have very good inventory control.

Reference
 Average Inventory Calculation - AccountingTools. (n.d.). Retrieved April 14, 2016, from
http://www.accountingtools.com/average-inventory-calculation

 Average Inventory Definition | Investopedia. (2010). Retrieved April 14, 2016, from
http://www.investopedia.com/terms/a/average-inventory.asp

 Inventory Turnover. (n.d.). Retrieved April 14, 2016, from

http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/inventory-
turnover-4803

 Inventory Turnover Ratio. (n.d.). Retrieved April 14, 2016, from

http://accountingexplained.com/financial/ratios/inventory-turnover