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Inventory turnover

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What is inventory turnover?

Inventory turnover is a financial ratio that measures how efficiently a company manages its stock of goods by showing how many times inventory is sold and replaced over a specific period, usually a year. This metric helps businesses understand the effectiveness of their inventory management and sales strategies, directly impacting profitability and cash flow.

Key takeaways

1
Efficiency indicator

Inventory turnover reveals how quickly a company’s products move from shelves to customers. High turnover signals strong sales or lean inventory, while low turnover may indicate overstocking or weak demand.

2
Formula

Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory

  • COGS is the direct cost of producing or purchasing goods sold during the period.
  • Average Inventory = (Beginning Inventory + Ending Inventory) / 2.

3
Industry benchmarking

Turnover ratios are most useful when compared to industry peers or historical trends, as “good” ratios differ by sector and business model.

4
Business decisions

Tracking inventory turnover helps optimize pricing, purchasing, marketing, and production strategies, ensuring inventory levels align with demand.

Why does inventory turnover matter?

Efficient inventory turnover helps manage costs by reducing expenses like warehousing, insurance, and spoilage, leading to better margins. It also improves cash flow by freeing up capital for reinvestment, unlike slow turnover, which locks cash in unsold stock. Moreover, maintaining the right inventory levels ensures product availability, boosting sales and customer satisfaction.


The inventory turnover process

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1
Calculate COGS

Sum the cost of all goods sold during the period (from the income statement).

2
Determine the average inventory

Add beginning and ending inventory values for the period, then divide by two.

3
Apply the formula

Divide COGS by average inventory to get the turnover ratio.

Impact on business and profitability

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Profitability: High turnover cuts holding costs and risk of obsolescence, boosting profits.

Cash flow: Rapid sales cycles release cash for growth initiatives.

Operational efficiency: Indicates effective inventory management and demand forecasting.

Impact on financial statements

Example calculation

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Scenario:

  • COGS: ₹5,00,000
  • Beginning Inventory: ₹1,55,000
  • Ending Inventory: ₹2,45,000

Average inventory:

(₹1,55,000 + ₹2,45,000) / 2 = ₹2,00,000

Inventory turnover ratio:

₹5,00,000 / ₹2,00,000 = 2.5

This means the company sold and replenished its inventory 2.5 times during the year.

Frequently asked questions about inventory turnover?

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It usually indicates strong sales and efficient inventory management, but could also signal insufficient stock to meet demand.

It may point to weak sales, overstocking, or poor merchandising. However, in some industries, low turnover is normal due to high-value or specialized goods.

Yes. Extremely high turnover might mean frequent stockouts and lost sales opportunities, especially if inventory levels are too low to meet demand.

By optimizing purchasing, pricing, and marketing strategies, and focusing on fast-moving products while reducing excess or obsolete stock.