Financial Statement Analysis and Inventory Turnover
|Inventory turnover is used to determine whether or not a business is maintaining adequate levels of inventory.|
How to Calculate Inventory Turnover
|Average Inventory = (Beginning Inventory + Ending Inventory)/2|
|Inventory Turnover = Cost of Goods Sold/Average Inventory|
Inventory turnover represents the number of times the inventory “turned over” during the period we are measuring.
Inventory turnover is generally higher in the retail industry. The inventory of equipment and machinery will turn over much less frequently, but will have a higher profit margin per product. Grocery stores and retailers of perishable goods have the highest inventory turnover, where profit margins are lower but sales are made in larger volumes. The financial ratio should be compared with competitors and the industry average.
Inventory Turnover Example
Let’s see how Sunny Sunglasses compares with its industry and competition:
Since Sunny Sunglasses Shop started business in January of 2010, there is no beginning inventory balance. Sunny knows that his ending inventory in 2010 is $5,625, and cost of goods sold for the year equals $43,200.
Plugging the numbers into the formula, we get inventory turnover of 15.36.
|($0 + $5,625)/2 = $2,812.50|
|43,200/2,812.50 = 15.36|
This means that Sunny Sunglasses Shop is turning over inventory 15.36 times per year.
Financial Statement Analysis
Industry Ratios: Inventory Turnover
The next step is to add meaning to this number by comparing it with the industry average:
|Company||Inventory Turnover Ratio|
|Sunny Sunglasses Shop||15.36|
|Specialty Retail, Other||10.0|
|Sunglasses Hut Int. (Luxottica Group)||3.2|
Inventory turnover for Sunny Sunglasses is about five times greater than that of its closest and largest competitor, Sunglasses Hut Int. (Luxottica Group) at 3.2.
This indicates that Sunny’s main competitor, Luxottica, may have products that are too expensive, or management may not have correctly estimated demand. It also means that Sunny Sunglasses is more in line with higher industry averages than its closest competitor. The company has more accurately forecasted demand while keeping inventory at an acceptable level with sales.
The retail sector generally has a higher inventory turnover than other industries, as products are less expensive and turnover more quickly. Holding inventories too long in the retail industry risks inventory write-downs, since seasonality and new product lines could quickly create lower demand and slower sales for older inventories.
The below disclosure exemplifies the retail sector’s fine balance of monitoring appropriate inventory levels throughout the year.
Nordstrom’s Inventory Management Disclosure, 2009
|We strive to ensure the merchandise we offer remains fresh and compelling to our customers. We make decisions regarding inventory purchases well in advance of the season in which it will be sold. If we are not successful at predicting our sales trends and adjusting our purchases, we may have excess inventory, which would result in additional markdowns and reduce our operating performance. This could have an adverse effect on margins and net earnings.
Conversely, if we fail to purchase enough merchandise, we may not have an adequate supply of products to meet our customers’ demand. This may cause us to lose sales or harm our customer relationships.
Another calculation, based on the inventory turnover financial ratio, is to determine how many days it took to clear the inventory. To calculate the number of days, simply divide 365 by the inventory turnover financial ratio:
Inventory Analysis and Industry Ratios
|Company||Inventory Turnover Ratio||Average Days to Clear Inventory|
|Sunny Sunglasses Shop||15.36||23.76|
|Specialty Retail, Other||10.0||36.5|
|Sunglasses Hut Int. (Luxottica Group)||3.2||114|
Software companies have very low inventory levels compared to other assets. The software industry has the advantage of maintaining low inventory levels since software is easily reproduced, which can lead to extremely high inventory turnover ratios.
Sunny Sunglasses Shop cleared its inventory every 24 days, while the Specialty Retail Industry averages 37 days. Luxottica Group is holding inventory for 114 days, three times longer than the industry average.