Inventory Turnover Ratio

How is it calculated?

Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory

Goal of the Ratio

The goal of this ratio is to determine how efficiently the business manages its inventory levels.  The ratio determines the turnover of inventory by dividing the business’s annual cost of goods sold by its average inventory level.  By doing this, the resulting ratio indicates how many times the business turns over (or buys, sells and buys again) the inventory that it has.  This ratio is very valuable to compare to peer averages to determine how much inventory your borrower has on hand versus a typical company in its industry.

If you find that a business has a low turnover ratio compared to its peers (AKA too much inventory for their total sales), you may be able to show the borrower the benefit to reducing its inventory and applying that freed up capital to other areas (reduce debt, distribution, investment in LT assets, etc)

If you find that a business has a high turnover ratio compared to its peers (AKA too little inventory for their total sales), you may find it valuable to discuss the impact of supply chain disruption could have on their business.  If they operate with limited inventory on hand, if their supply chain gets interrupted, it may prevent them from making additional sales (AKA not good!).

When is it used?

This is a typical ratio to use when a company’s business holds a lot of inventory.  Examples of businesses like this would be retailers or wholesalers.  

Rules of Thumb

There is no clear rule of thumb for this ratio as it varies considerably from industry to industry.  Your best bet is to always view this ratio in relation to its peer averages.

Please note all ratios should be viewed in relation to industry norms to determine overall adequacy.

What changes in the ratio could mean:

Some example reasons why the Inventory Turnover Ratio can change:

Increasing

1. Rising revenue
2. Supply chain interruptions lead to lower inventory

Decreasing

1. Purchase additional inventory in anticipation of rising revenue
2. Adding a product line
3. Declining revenue

Other Relevant Terms

• Capital
• Balance Sheet
• Working Capital
• Days Inventory Outstanding
• Return to Terminology Library