The inventory turnover calculator, a tool for calculating financial efficiency ratios, employs the formulas for inventory turnover and inventory days to estimate how rapidly a company’s stock is sold in a particular period of time.
If management practises are monitored on a trend basis, it may be shown to investors whether they are improving the effectiveness of their production, manufacturing, or selling process.
What exactly is inventory?
Inventory, by definition, refers to products that are finished and available for sale as well as raw materials for production. It includes all material process modifications as a result.
Some businesses might buy manufactured goods from multiple suppliers and resell them to their clients, like apparel retailers, while other businesses might buy pig iron and coke to start making steel.
The possibilities are unlimited because both will keep track of these products as inventory, but because inventory control is so crucial to the operation of the firm, establishing strategies for inventory control becomes vital.
In accounting terminology, inventory is viewed as a current asset on the balance sheet. It has a high level of liquidity, thus we anticipate that it will be converted into cash quickly (less than one year).
Cost of Goods Sold, or COGS as it is more often known is the term used to describe the costs incurred by the business in producing the finished product after it has been sold. Depending on your accounting method, COGS may be higher or lower. For further details, see FIFO and LIFO.
Current assets are said to include inventory.
Investors must monitor inventory levels as part of current assets since doing so enables them to monitor overall company liquidity. This means that whatever short-term debt a firm may have can be paid off with the income it receives from inventory sales. If you want to understand more about liquidity, how to assess it, and other financial ratios, check out our current ratio and fast ratio calculator.
As a gauge of financial efficiency- inventory turnover
Cash is required for a company’s activities. Lenders and investors must support it from the beginning. Once the business is up and operating, cash is obtained for sustaining operations through the sale of goods (cash inflow) and short-term commitments from lenders or suppliers (cash outflow)
To prevent this chain—also referred to as the cash conversion cycle—from breaking, inventory turnover is necessary. A corporation obtains more cash the more effectively and quickly this happens, making it more resilient to market volatility. It’s crucial to keep in mind that the corporation sells more inventory over time if the Cost of Goods Sold figure is higher.
Inventory turnover reveals the average number of times over the time frame under consideration that the inventory was sold and recorded as such. Contrarily, inventory days show the investor how long it typically takes to sell a certain amount of goods.
Let’s assume that Company A sells its goods 14 times year, or a 14 percent inventory turnover ratio. We can then determine that it takes the company 26 days to sell its entire average amount of inventory by dividing 365 days by 14.
The calculation of the inventory turnover ratio is covered in more detail in the following paragraphs.
Two further figures to take into account as important additional instruments for figuring out a company’s profitability are EBIT and free cash flow.
How do you calculate days on hand and inventory turnover?
We must consider the study’s time span before examining the inventory turnover calculation.
The most usual time frames are 90 days for quarter calculations and 365 days for the complete fiscal year. We’ll pick the first period in this article because it takes into account any seasonality impacts that might develop over the course of the year.
Analyze your inventory levels at the beginning and conclusion of the fiscal year. This value for the Beginning and Ending Inventory, respectively, may be found by looking at the annual balance statements for 2018 and 2019. Next, we average the two sets of inventory data:
(Beginning inventory plus ending inventory) / 2 equals average inventory.
To make sure, we determine the turnover ratio after extracting the Cost of Goods Sold (COGS) from the year’s income statement:
COGS / average inventory is a measure of inventory turnover.
Additionally, once we have the ratio, we can use the calculation of inventory days to ascertain the number of days on average that a quantity of inventory is handed over:
365 days of inventory divided by the inventory turnover
Of course, you won’t need to memorise these formulas like you would in school because you have our beloved Omni inventory turnover calculator on your left.
What can investors take away from the turnover of inventory?
We’ll start by talking about what we don’t have to do when examining the ratio and the days separately. They become just numbers when seen in this context.
The trend determines the importance of these values. We can then decide if efficiency increases or decreases after gathering data for three to five years.
In terms of inventory turnover, the larger the number, the better. In order to create the entire value recorded as Cost of Goods Sold, the inventory must have been sold on average more than once, according to a high turnover value. On the other side, a low number suggests that the business only processes its inventory occasionally.
The better the number of inventory days, the lower it should be. A high number of inventory days suggests that the company spends a lot of time rotating its products, which suggests that it takes longer to sell those products for cash to keep operations operating. In contrast, a company will be in a stronger financial position if it can sell off its inventory in less time since cash inflows would be more regular.
As a result, as an investor, you want to see a long-term increase in the inventory turnover ratio and a decrease in the number of inventory days.
A company’s inventory turnover may be increasing for three reasons.
The top three reasons a company could be able to enhance inventory management are as follows:
The business is attempting to enhance its purchasing practises. It’s likely that the company has discovered superior suppliers, making the process of acquiring raw materials simpler and faster.
It’s possible that the company’s production process has been improved, allowing items to be ready for sale faster.
The company is expanding more quickly. A company may be able to manufacture exactly what clients want after conducting market research, creating marketing strategies, or increasing market share, leading to the sale of the majority of its products in a shorter amount of time.
On the other side, worsening inventory ratios could be a sign that a company’s growth is slowing. This might be a result of problems with suppliers, production processes, or rivalry.
This deterioration is crucial for cyclical businesses like automakers or commodity-based ones like steelmakers. If a company is buying up more stock every quarter, a problem is undoubtedly growing, and if you own shares in that company, you may want to consider selling and taking profits.