Basics of Inventory Turnover Ratio

What can make a business successful? A management team full of MBAs? Or a diverse range of products and services? No. All these factors can make a business efficient. A company’s profitability is directly linked to how quickly it can sell its inventory. This is true for every business. From the roadside tea stall vendor to the owner of a Mercedes Benz showroom. Inventory is the goods and services that a company produces but hasn’t sold yet. For Nike, its shoes. For Monginis, its cakes and pastries. And for Maruti Suzuki India Ltd, its cars. But only producing goods is not enough. Will Nike make money if it only produces shoes? No! They will have to sell these shoes to make real money. A company makes money only if it sells its inventory in a specific period of time. The frequency at which a company sells its inventory is known as Inventory turnover ratio. It measures a company’s efficiency in inventory management. A high inventory turnover ratio is ideal. It shows that there is high demand for a company’s products and services. It is especially useful while evaluating Fast Moving Consumer Goods (FMCG) companies. In this article: 
  • What is the meaning of inventory turnover ratio?
  • How to calculate inventory turnover ratio?
  • How does inventory turnover ratio work in stock analysis?
  • FAQs on inventory turnover ratio.
Inventory Turnover Ratio

What is the meaning of inventory turnover ratio?

Inventory turnover ratio is the number of times a company sells its entire inventory in a year. Hindustan Unilever Ltd.’s inventory turnover ratio is 6.98. This means that HUL sells its entire inventory 6.98 times in a year. Whereas the inventory turnover ratio of Jindal Steel & Power Ltd is only 1.74. Inventory turnover ratio is also known as stock turnover ratio or stock turns. It is an activity ratio which shows the number of times a company sells, restocks or consumes its inventory. A high inventory turnover ratio is ideal. It shows that a company’s products are in high demand. It also tells you that the company is selling its products at a faster rate. More sales means more revenue. A high stock turnover ratio frees up a company’s cash flows. So, it can produce more goods and make more money. It is an endless cycle.
Inventory Turnover Ratio
One of the reasons for a low inventory turnover rate is weak sales. This happens when the demand for a product falls. This leads to an increase in dead or obsolete inventory. These are items which are at the end of their product life cycle. Maintaining unsold inventory is expensive for companies. They have to pay for storage costs, insurance, rent, utilities etc. It also adversely affects a company’s cash flow. It can no longer spare funds to produce new products or expand its presence. The end result is lower profits. Generally, turnover of FMCG companies is higher than real estate, steel or power companies. It is mostly used to analyse sectors which have tangible inventory. This includes FMCG, Departmental stores etc. It does not work for Information & Technology (IT) or service sector companies. [Must Read: Best FMCG Stocks to Buy in India]

Understanding Inventory Turnover Ratio with an Example 

Let us understand how inventory turnover ratio works with this simple example. You want to buy a cake. So, you visit a cake shop, but the cakes are not fresh. They are yesterday’s unsold cake. Will you buy this stale cake? Most probably not. You will instead visit another cake shop which is selling freshly baked cakes. For the cake shop owner, cakes are inventories. The frequency at which he sells the cakes is his inventory turnover ratio. He has to maintain a high turnover ratio as customers will not buy stale cakes. The more cakes he sells, the more money he has to bake fresh cakes. This will bring in more customers and increase his profits. Notice how inventory turnover ratio is closely tied to a company’s profits. The below table shows the turnover ratio of top companies in 2/3 wheeler sector.
2/3 Wheeler Companies Inventory Turnover Ratio Market Capitalisation (Rs Cr)
Bajaj Auto Ltd 15.3 1,22,313
Eicher Motors Ltd 7.07 73,999
Hero MotoCorp Ltd 14.2 58,078
TVS Motor Company Ltd 10.1 29,202
Maharashtra Scooters Ltd 2.33 4,267
Atul Auto Ltd 8.6 418
Scooters India Ltd 1.36 329
Majestic Auto Ltd 5.8 141
Kinetic Engineering Ltd 0.49 93
Notice that Bajaj Auto Ltd has the best inventory turnover ratio. This means its bikes are more in demand. The company enjoys higher revenues. With high cash flow, it can launch new bikes, expand overseas etc. On the other hand, Kinetic Engineering Ltd has the worst turnover ratio. The company is unable to sell its inventory once in the entire year. It won’t have the funds to launch new products or spend on marketing. A consistently falling inventory turnover ratio is a BIG red flag for investors.  In short, a higher inventory turnover ratio is always preferred. Inventory turnover ratio tells you how often a company restocks its entire inventory. But it is also important to understand how many days it takes to sell its inventory. This is known as Days Sales of Inventory (DSI).  DSI is the number of days it takes a company to sell its inventory. As expected, the lower the DSI, the better it is. DSI Formula = (Average Inventory / Cost of Goods Sold (COGS) * 365 days.  Or you can simply divide 365 by your inventory turnover ratio. For example: The inventory turnover ratio of Marico Ltd is 3.41. So, its DSI will be 107 days (365/3.41). So, it takes 107 days for Marico Ltd to sell its inventory. And it sells its inventory 3.41 times in a year.

How to Calculate Inventory Turnover Ratio? 

Inventory turnover ratio formula = Cost of Goods Sold (COGS) / Average Inventory.  To calculate inventory turnover ratio, you have to divide COGS by average inventory. COGS is the actual cost of making a product. We can calculate it by subtracting gross profit from the selling price. It is readily available in the company’s income statement. For example: The sale price of iPhone 12 Pro Max is Rs 1,53,500. Let’s assume that Apple makes a profit of Rs 20,000 per unit. In this case, the COGS will be Rs 1,33,500 (Rs 1,53,500 – Rs 20,000). While calculating inventory turnover ratio, use average inventory instead of closing inventory. The reason being, a company’s inventory levels fluctuate widely. Especially during holiday seasons or for the companies which are cyclic in nature. Avenue Supermarts Ltd (D’mart) might have huge amounts of inventory before Diwali. However, this will drop drastically post the festivities. Hence, average inventory is considered to calculate inventory turnover ratio. It helps us find a better estimate of the ratio. Average Inventory = (Opening Inventory + Closing Inventory)/ 2.  Both opening and closing inventory is available in a company’s balance sheet. Some investors use annual sales instead of COGS. But this can show an inflated figure. Sales also include a profit mark-up and are not the same as COGS. Hence, always consider COGS instead of annual sales to calculate inventory turnover ratio.

What is the Ideal Inventory Turnover Ratio?

The ideal stock turnover ratio varies across sectors. Luxury products usually have lower inventory turnover ratio. Let’s understand this with an example. You see the difference! With such diverse range, what is the ideal inventory turnover ratio? The ideal inventory turnover ratio is between 5 and 10. So basically, the company restocks its entire inventory every one to two months. We understood why higher turnover ratio is always ideal. But remember that excess of it can be harmful as well. A company with excess inventory has very less liquidity. So, even the slightest glitch in its supply chain will affect its demand. This ultimately affects the company’s profit. A low inventory turnover ratio can mean that the company is unable to sell its inventory on time. This leads to dead inventory. It increases a company’s storage costs, insurance, rent, maintenance costs etc.

How to Use Inventory Turnover Ratio in Stock Analysis 

There are two ways to use inventory turnover ratio in stock analysis:
  • Analysing five year trend
  • Analysing against industry turnover ratio
Analysing a company’s five-year inventory turnover ratio trend is a must for investors. It can show you early signs of trouble. A consistently falling turnover ratio can be a red flag for investors. It suggests slowing demand and sales. The below graph shows the five year inventory turnover ratio of Divi’s Laboratories Ltd.
Inventory Turnover Ratio
In 2018, Divi’s Laboratories Ltd restocked its 2.98 times. But this increased to 3.33 times in 2021. In comparison, let us check the five-year inventory turnover ratio of Dr Reddy’s Laboratories Ltd.
Inventory Turnover Ratio
As you can see, there was a drastic fall in inventory turnover ratio from 5.41 in 2020 to 4.73 in 2021. Remember our cake shop example. There is a direct relationship between number of days it takes to sell something and a company’s profitability. Hence it is important to compare 5-year inventory trend with sales growth to conclude if a company is indeed in trouble. Let’s have a look at the table below. Here is Godrej Consumer Products Ltd. ‘s inventory turnover days and sales data.
Inventory Turnover Ratio
We can ignore 2020 as it was a pandemic year. But even between 2018 and 2019, its net sales were down by 24%. Same happened during 2017-18, when net sales fell by 38%. An increase in DSI along with a fall in net sales growth is an early red flag for investors. It is one of the reasons why Godrej Consumer Products Ltd is a 2-star rated stock.

Analysing against industry turnover ratio 

Every sector has a different turnover ratio. Average industry turnover ratio of Departmental stores is 3.55. Whereas it’s 7.53 times for cars and utility vehicles sector. Hence inter-sector comparison is pointless. You can find out which company has the best growth prospects by comparing its inventory turnover ratio with its peers.
Inventory Turnover Ratio
  As you can see, Godrej Consumer Products Ltd and Gillette India Ltd have the worst inventory turnover ratio in the personal products sector. Remember, a company that sells products faster, will generate higher profits for itself as well as its investors. Most investors do not consider inventory turnover ratio while analysing stocks. But this is a big mistake. This crucial ratio can reveal potential red flags in a company. Therefore, pay close attention. Especially while evaluating FMCG and personal products sectors. Inventory turnover ratio is just one of the 20 million data points that you need to analyse in a company. And you need to do this for more than 4,000 stocks in the market. Seems daunting isn’t it? DDon’t worry. We have a shortcut for you. Simply open a FREE Samco Demat account and get unconditionally free access to Samco’s Star Ratings and get instant rating of all stocks listed in India.

FAQs on Inventory Turnover Ratio 

  1. What is inventory turnover ratio?
Inventory turnover ratio tells you how many times a company sells its entire inventory in a specific period of time. The higher the ratio, the more demand a product has.
  1. Is a high inventory turnover good or bad? 
A high inventory turnover is both good and bad. It is good as it means demand for the company’s products is very high. But it can also mean that the company is understocking its products and missing out on potential sales.
  1. What does an inventory turnover ratio of 5 mean? 
An inventory turnover ratio of 5 means that the company is selling its entire inventory five times in a specific period. So, basically it takes them 72 days to sell inventory (365/5).
  1. Is a low inventory turnover ratio good?
No, a low inventory turnover ratio is not good. It indicates weak sales, low product demand, inefficient cash flow and poor liquidity. The ideal inventory turnover ratio is between five and ten.
  1. How do I calculate inventory turnover ratio? 
Inventory turnover ratio is calculated by dividing cost of goods sold (COGS) by average inventory.
  1. How do you calculate Days sales of inventory? 
To calculate inventory turnover days, simply divide 365 days by inventory turnover ratio. For example: inventory turnover ratio of Eicher Motors Ltd is 7.07. So, its DSI will be 51.62 days (365/7.07)
  1. What is average inventory? 
A company’s inventory can fluctuate drastically especially before and after holidays or big sales. Hence it is better to use average inventory while calculating inventory turnover ratio. Average inventory formula = (Opening inventory + closing inventory)/2

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