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Inventory turnover helps you determine the health of a business. Bankrate explains.
What is inventory turnover?
Inventory turnover is the number of times a business sells or uses inventory over the course of a defined time period. It’s a good way to measure the health of a business against an industry average, as a low turnover rate suggests an inability to move goods.
It’s easy to think of inventory turnover in terms of a ratio of net sales over inventory. In its more basic form, it can be expressed as the equation Inventory Turnover = Net Sales / Average Inventory. That gives you a ratio showing how quickly a company is able to move units.
However, it’s more accurate to calculate it using the cost of goods sold (COGS), which is the cost of creating your goods. The equation remains the essentially the same: Inventory Turnover = COGS / Average Inventory. That calculation usually results in a lower inventory turnover ratio because it takes markup into consideration.
Not every low turnover ratio indicates something negative. While it could mean overstocking or obsolescence, sometimes a low turnover rate helps a business in times of market shortages. Similarly, while a high inventory turnover rate suggests profitability, it can lead to a loss of business if shortages occur.
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Inventory turnover example
Martha sells cat toys. Last year, she had $200,000 worth of cat toys in inventory. On January 1st, she adds an additional $4,000 worth of cat toys to the inventory. By December 31st, she has sold $150,000 worth of cat toys.
Her remaining inventory is $54,000 worth of cat toys, so her cost of goods sold ($200,000 + $4,000 – $54,000) is $150,000.
She wants to calculate her inventory turnover. First, she calculates her average inventory: $200,000 + $54,000 / 2 = $127,000.
Now, she divides that her COGS over average inventory: $150,000 / $127,000 = 1.18, which is her inventory turnover ratio.
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