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What is the inventory turnover ratio? The formula for calculating this metric includes the cost of goods sold and net sales. This can be used to analyze a company’s efficiency since it compares how many times its assets were bought vs. sold during an accounting period.
The inventory turnover ratio is a measurement of how rapidly inventory is converted into sales. A high inventory turnover ratio is usually considered beneficial and suggests that a corporation has strong inventory management, while a low ratio implies the reverse. This rule has certain exceptions, which we will discuss in this article.
Calculating your inventory turnover ratio is simple if you use accounting software like QuickBooks. To gather the data you need, run a profit and loss report and a couple of balance sheet reports. QuickBooks also helps you to keep track of all of your earnings and spending.
What Is Inventory Turnover Ratio and What Does It Mean?
The inventory turnover ratio is the number of times a firm sells and replaces merchandise during a certain time period, which is usually a year. While you shouldn’t make conclusions based only on this information, high turnover is typically a positive sign that a firm is managing its inventory well.
The formula for the inventory turnover ratio is as follows:
Inventory turnover ratio = cost of goods sold / average inventory
What is the Inventory Turnover Ratio and How Do You Calculate It?
The inventory turnover ratio is derived by dividing the cost of items sold by the average inventory over a certain period of time. The cost of goods sold is calculated by summing the direct costs of materials and labor required in the production of a product. On a profit and loss statement, this amount is right underneath revenue.
The average inventory is the second component. The average inventory is calculated by adding the inventory at the start and the inventory at the conclusion of the period, then dividing the result by two. Your balance sheet report will show both your starting and ending inventory. The cost of your inventory as of January 1 (or the start of your fiscal year) is the starting inventory figure, and the cost of your inventory as of December 31 is the ending inventory figure (or the end of your fiscal year).
Because inventory changes throughout the year for many businesses, calculating your ratio using the average inventory for the period is more accurate than using the ending inventory. If your inventory does not change much, however, utilizing the ending inventory rather than the average inventory may be appropriate.
1. Determine the cost of the goods sold
As previously stated, all materials and labor needed to make the items or services you sell are included in the cost of goods sold. If you utilize accounting software, you may calculate your cost of products sold by running a profit and loss report. Take initial inventory plus purchases throughout the period and subtract ending inventory to compute the cost of goods sold manually.
The cost of products sold is calculated using the following formula:
Cost of goods sold = (Beginning inventory + acquisitions) – Ending inventory
Example of Cost of Goods Sold: ABC Company Assume ABC Company has a $10,000 starting inventory and makes $50,000 in acquisitions over the course of the year. It has a final inventory of $20,000 on hand. ABC Company’s cost of goods sold is computed as follows:
Cost of goods sold = Beginning inventory + Purchases – Ending inventory
$10,000 minus $50,000 minus $20,000 equals $40,000
2. Determine the average inventory
You must take inventory at the start of the period (for example, January 1) and add it to the inventory balance at the conclusion of the term to compute the average inventory. Take that number and divide it by two to obtain the year’s average inventory. You may acquire your inventory figures by running a balance sheet report.
The following is the formula for calculating average inventory:
Average inventory = (Beginning inventory + Ending inventory) / 2
ABC Company, as an example, has an average inventory. Assume ABC Company’s balance statement as of January 1 displays a $20,000 starting inventory and a $30,000 ending inventory as of December 31. ABC Company’s average inventory is computed as follows:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
$20,000 ($20,000 + $20,000) divided by two equals $20,000
Calculate the Inventory Turnover Ratio (ITR).
We can compute the inventory turnover ratio now that we’ve established the cost of goods sold and average inventory for ABC Company. We’ll divide the cost of goods sold by the average inventory to get the ratio.
The following formula is used to determine the inventory turnover ratio:
Inventory turnover ratio = cost of goods sold / average inventory
$40,000 / $20,000 = $40,000 / $20,000 = $40,000 / $20,000 = $40,000
What Does the Inventory Turnover Ratio Mean?
In general, a high inventory turnover ratio shows that a company is highly good at managing its inventory. A low ratio might indicate that a company’s inventory is poorly managed. Your industry can assist you in determining if your turnover ratio is satisfactory or requires improvement.
Grocery businesses, for example, have a greater inventory turnover ratio than other retailers because they offer lower-cost items that deteriorate rapidly. Car manufacturers, on the other hand, have a low inventory turnover rate since they offer high-value commodities that require time to create. The goal is to figure out what the industry standard ratio is so you can compare your ratio to others in your field.
It’s also worth noting that a high inventory turnover rate might indicate that you’re losing out on potential sales since you can’t have enough goods on hand to fulfill demand. A poor inventory turnover ratio, on the other hand, may suggest that you buy more products than you can sell, resulting in outmoded inventory and increased warehouse storage expenses.
Examples of Inventory Turnover Ratios
We’ll go through a few scenarios in this section to show how to calculate inventory turnover. A quick explanation of what the inventory ratio signifies for the firm is also offered.
XYZ Company’s Inventory Turnover Ratio Assume XYZ Company has a $25,000 cost of goods sold, $100,000 in starting inventory, and $60,000 in ending inventory.
The following is how XYZ Company’s inventory turnover ratio is calculated:
Inventory turnover ratio = cost of goods sold / average inventory
Inventory turnover ratio: $25,000 / ($100,000 + $60,000)/2 =.31
A .31 ratio indicates that just approximately a third of XYZ Company’s inventory was sold throughout the year. This shows that the organization has poor inventory management, implying that the buying department and the sales department are out of sync.
ABC Company’s Inventory Turnover Ratio Assume ABC Company has a $60,000 cost of goods sold, $100,000 in starting inventory, and $25,000 in ending inventory.
ABC Company’s inventory turnover ratio is computed as follows:
Inventory turnover ratio = cost of goods sold / average inventory
Inventory turnover ratio: $60,000 / ($100,000 + $25,000)/ 2 =.96
ABC Company sold virtually all of its inventory over the year, according to a .96 ratio. This suggests that the corporation maintains effective inventory management and that stock purchases correspond to sales.
Creating Reports to Calculate Inventory Turnover Ratio
To calculate your inventory turnover ratio, you’ll need access to your starting and ending inventory, as well as the cost of products sold. You can produce the information you need to calculate your inventory turnover if you have accounting software. The profit and loss report for the whole year, as well as the balance sheet reports for the beginning and conclusion of the year.
How to create a balance sheet report in QuickBooks Online
Navigate to the Reports menu in QuickBooks Online and pick the balance sheet report from the business overview area. Refresh the report by changing the date.
To produce a balance sheet statement in QuickBooks Online, follow the instructions below.
1. Select Reports from the drop-down menu.
Select Reports from the left menu bar, as shown below:
In QuickBooks Online, go to Reports.
2. Select the Balance Sheet Report from the drop-down menu.
As seen below, choose the balance sheet report from the Business overview reports section:
In QuickBooks Online, go to the Balance Sheet tab.
3. Choose a date for your balance sheet report to be generated.
The following report contains data as of January 1, 2019, the start of the period:
QuickBooks Online Sample Balance Sheet Report
4. To create the balance sheet report for the end of the period, change the date range.
We’ve modified the date range in the example below to the end of the period, December 31, 2019:
QuickBooks Online Sample Balance Sheet Report
How to make a profit and loss report
Navigate to reports and pick the profit and loss report from the business overview reports area to produce a profit and loss report in QuickBooks Online. For the time period for which you wish to run the report, enter the date range.
To create a profit and loss report in QuickBooks Online, follow the instructions below.
1. Select Reports from the drop-down menu.
Select Reports from the left menu bar, as shown below:
In QuickBooks Online, go to Reports.
2. Select the Profit & Loss Report from the drop-down menu.
As seen below, choose the profit and loss report from the Business overview reports section:
In QuickBooks Online, go to the Business Overview and choose the Profit and Loss Report.
3. To build your profit and loss report, choose a date range.
The following report covers the period from January 1 to December 31, 2019:
Using QuickBooks Online, create a sample profit and loss report.
Example of Inventory Turnover Ratio for Paul’s Plumbing Co.
The inventory turnover ratio is derived using the balance sheet and profit and loss data obtained for our imaginary firm, Paul’s Plumbing (above):
Inventory turnover ratio = Cost of goods sold / (Beginning inventory + Ending inventory) / 2
$1.41 = $32,500 / ($2,750 + $20,250) / 2
Paul’s Plumbing had a turnover ratio of 1.41, which implies they sold out of their inventory roughly 1.5 times throughout the year. This implies that Paul’s Plumbing has strong inventory management, indicating that purchases match sales.
Comparing the Inventory Turnover Ratio to Inventory Days Sales
The amount of days it takes to transform inventory into sales is measured in days sales of inventory, also known as days inventory. It’s determined by dividing average inventory by cost of products sold, then multiplying by 365 days.
The formula for calculating days sales of inventory (DSI) is as follows:
DSI = (Average Inventory/Cost of Goods Sold) x 365
Paul’s Plumbing is an example of a DSI. Assume Paul’s Plumbing has a $25,000 average inventory and a $80,000 cost of goods sold. To calculate the DSI, divide average inventory by cost of goods sold and multiply by 365.
Paul’s Plumbing has the following DSI:
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
- 114 days = ($25,000 / $80,000) times 365 days
- 114 days = ($25,000 / $80,000) times 365 days
- 114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
114 days = ($25,000 / $80,000) times 365 days
Frequently Asked Questions
What is the inventory turnover ratio?
Inventory turnover ratio is a measure of how often goods are sold, converted into cash and then replaced by new goods. It tells us what percentage of revenue comes from sales versus the cost to produce those items.
How do I calculate the turnover ratio?
The turnover ratio is calculated by dividing the revenue of a company in one year by its total assets. The higher the turnover, the more efficient your business is at generating profit.
