Imagine two online retailers selling products for home gardeners. Both companies hold about $1 million in stock generally. However one company turns its inventory 10 times annually and another just five times. The company with 10 inventory turns should experience better cash flow and more sales.
Thus, inventory turnover — and the related stock turnover ratio — is a powerful key performance indicator.
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Inventory Turnover Ratio
There are at least a couple of approaches to calculate a stock turnover ratio: (I) total earnings divided by end stock or (ii) cost of goods sold divided by average inventory.
The calculations produce various outcomes. The method you choose depends on which delivers a better view of your organization’s inventory and sales performance.
Revenue and ending inventory. Many investors use a supplier’s earnings and its ending inventory to calculate its inventory turnover ratio.
Earnings ÷ End Inventory
By means of example, for the fiscal year ended January 31, 2020, The Home Depot reported total earnings of $110.2 billion, a cost of revenue (about the cost of goods sold) of $72.7 billion, and an inventory balance of $14.5 billion (that I will use as a stand-in for the finish stock and average inventory), based on Yahoo! Finance.
We can calculate inventory turnover for one public company (such as The Home Depot) and estimate the average turnover for an entire industry.
Applying this method we can compute Home Depot’s stock turnover ratio as 7.6. Home Depot turns over its inventory about 7.6 times each year.
$110.2 billion ÷ $14.5 billion = 7.6
If we wanted to know home many days it takes The Home Depot to reverse its inventory after, we can split the number of times in the year by the inventory turnover ratio we just calculated.
365 ÷ 7.6 = 48 times
Using this procedure, we would estimate the Home Depot turns its inventory about once every 48 days. This method is generally a bit optimistic since it has the supplier’s profit when it takes complete sales because its numerator.
COGS and standard inventory. Another technique is to divide the cost of goods sold from the average inventory for the period of time in view. This typically provides a more accurate view of inventory turnover because it excludes any markup.
COGS ÷ Average Inventory
Let’s continue with The Home Depot example, with $14.5 billion in typical inventory and approximately $72.7 billion to the cost of merchandise sold.
$72.7 billion ÷ $14.5 billion = 5
Notice this system creates a different stock turnover ratio. In cases such as this, we would estimate the Home Depot turns its inventory about once every 73 days.
365 ÷ 5 = 73 times
This calculation, which is called”Days’ Sales of Inventory” or”Days’ Inventory,” can gauge how long it takes to be given a return on investment for inventory purchases.
Interpreting Inventory Turnover
Knowing your company’s inventory turnover ratio won’t necessarily help you understand how the organization is performing. For that, you need context.
First, estimate the average stock turnover ratio to your company. If you sell construction materials, tools, and items for do-it-yourself tasks, calculating inventory turnover for companies like Home Depot and Lowe’s could offer circumstance.
Moreover, you could find company inventory turnover estimates online. A quick Google search, for example, shows that grocery stores typically have an inventory turnover of 40.
Next, benchmark your company’s inventory turnover. Review your financial information and calculate an inventory turnover ratio for each and every month, quarter, and year for at least the past couple of years. Equipped with an industry average and your company’s benchmark, it is possible to better estimate your stock performance.
High inventory turnover. by means of example, a relatively substantial stock turnover in comparison with the business or your prior performance is a fantastic indicator of healthy earnings and effective purchasing. Your company is apparently making great stock investments without overstocking.
However a high stock turnover could also indicate too few purchases. Are you, by means of example, running from inventory?
Low inventory turnover. Conversely, if your company’s stock turnover is reduced when compared to your organization or your own previous performance, you probably have a sales or buying difficulty.
Low earnings could indicate that demand for your products is waning or new competitors have entered the market.
A relatively low stock turnover could also signify that you’d dead inventory or your company has been placing too many orders.
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