What inventory turnover tells you
Cost of goods sold is what the goods sold during the period cost the business. Inventory is the stock it holds on a given date, which for a manufacturer includes raw materials and work in progress as well as finished goods. The balance sheet carries inventory at cost, so the ratio divides by cost of goods sold rather than sales to compare like with like.
A result of 6.00 means the business sold an amount equal to its average inventory six times during the period. Over a 365-day year, that means stock was held for about 61 days on average before it was sold. That day count is called days inventory outstanding, and it is one of the three parts of the cash conversion cycle.
Reading a high or low result
What is normal depends on what the business sells. Perishable or everyday goods usually turn over far more often than expensive items that customers buy rarely.
- A higher turnover means inventory sells faster relative to the amount held, so less cash is tied up in stock. It can also mean the business holds too little and loses sales when items run out.
- A lower turnover can point to slow-moving or obsolete stock, over-buying or weaker demand. It may also be deliberate, for example building stock ahead of a busy season or keeping a wide range on hand.
Compare the ratio with the same business in earlier periods, or with businesses that sell similar goods.
What the ratio does not show
- It is an average across every product. A few fast sellers can hide lines that have not moved for months.
- The method used to assign costs to inventory, such as first-in, first-out or weighted average cost, changes both cost of goods sold and the inventory balance when prices are moving.
- Writing down damaged or obsolete stock lowers the inventory balance and can make turnover look faster without any change in sales.
- It says nothing about the margin earned on what was sold.
Average vs ending balances
Cost of goods sold covers the whole period, but inventory is counted on a single date. Averaging the opening and closing balances gives a fairer match, especially when stock levels rose or fell during the year. To use the average, open “Add opening balances to use averages” and enter inventory at the start of the period. If you leave it blank, the calculator divides by ending inventory, which gives a different answer whenever inventory changed. Even an average of two dates can miss a seasonal peak, so treat the result as an approximation for a seasonal business.
Common mistakes
- Dividing revenue by inventory. Some sources do this, but it mixes selling prices with costs and gives a higher figure, so it cannot be compared with the cost-based ratio. Check which version a published figure uses.
- Using a quarter’s cost of goods sold and comparing the result with annual figures. A quarterly turnover is much lower simply because the period is shorter.
- Comparing businesses that value their inventory with different cost methods.
- Treating a higher figure as always an improvement. Running stock too low can cost sales and customers.
Related measures
The cash conversion cycle combines the days inventory is held with the time taken to collect from customers and to pay suppliers. Days payable outstanding uses the same cost of goods sold to measure how long the business takes to pay for what it buys. Asset turnover takes the wider view and compares revenue with all assets. The quick ratio leaves inventory out of its liquid assets because stock can take time to sell.