Inventory Turnover and Days Inventory on Hand

Inventory management is crucial to the success of a firm. Too much inventory means paying for storage, possible waste or theft, and the opportunity cost that the time and space used to hold onto inventory that remains unsold could have been used instead to buy products that would sell. Having too little inventory, on the other hand, could lead to shortages and possibly missed sales opportunities.

Inventory turnover is an activity ratio that measures the company’s effectiveness by dividing cost of goods sold (an income statement item) by the average inventory balance (a balance sheet item.) Since cost of goods sold represents the inventory that leaves the firm, the ratio allows the investor to see how frequently the company needs to replenish its existing inventory.

As an example, consider the following information from Wal-Mart’s 10K for the fiscal year ended January 31, 2006.

wmt.jpgThe first thing to recognize is that the income statement represents what happened over the course of the entire year, whereas the balance sheet reflects only a particular date (January 31.) By taking the average of the two year-end numbers we can get an estimate of the typical inventory balance during the year, which is more comparable to the income statement data.

wmt1.jpgBy dividing cost of sales by the average inventory we see that on average Wal-Mart is selling everything it has nearly eight times per year. This number can be tracked over time or compared to other similar companies to see how well the company is managing its inventory. Generally, a higher number is better. However, a number too high might suggest the company is selling merchandise faster than it can be replenished. If a company runs out of a particular item it risks losing sales to a competitor who has the item in stock.

If we divide the inventory turnover into 365 we can estimate how many days worth of inventory is on hand. This ratio, not surprisingly, is called Days Inventory on Hand (often represented as the Simpsons-esque DOH! – which is what management says when the inventory is either too high or too low.)

For Wal-Mart, the days on hand are 365/7.8 = 46.8. In this case, a lower ratio would represent more effective inventory management, all else being equal.

For more information, see all articles on: Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis, Security Selection

See also:
  • Activity Ratios
  • The Cash Cycle
  • Accounts Receivable Turnover and Days Sales Outstanding
  • Accounts Payable Turnover and Days Payable
  • How the Inventory Accounting Method Affects the Income Statement
  • Technical Analysis Explained : The Successful Investor's Guide to Spotting Investment Trends and Turning Points

    The Intelligent Investor: The Classic Text on Value Investing

    Financial Statement Analysis: A Practitioner's Guide, 3rd Edition

    Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)

    4 Responses to “Inventory Turnover and Days Inventory on Hand”

    1. Accounts Receivable Turnover and Days Sales Outstanding - Financial Education - Everything You Need To Know About Finance Says:

      [...]     « Accounts Payable Turnover and Days Payable Inventory Turnover and Days Inventory on Hand [...]

    2. Chip Supply Issues Now Hurting Demand - Stock Market Beat - Our beat is the stock market. Our job is to beat it. Says:

      [...] demand for semiconductors has experienced fairly steady growth, excess supply has sometimes caused inventory to grow to unsustainable levels. For example, “by 2000 most of the capacity was in place, [...]

    3. TPX: Did Tempur-Pedic Declare Victory Too Soon on Production Issues? - Stock Market Beat - Our beat: The stock market. Our job: Beat it. Says:

      [...] March, the Albuquerque plant had considerably expanded its throughput which allowed us to build inventory and eliminate backorders. As a result, we believe we have ample levels of mattress [...]

    4. MU: DRAM Correction Playing Out Pretty Much As We Said it Would - Stock Market Beat - Our beat: The stock market. Our job: Beat it. Says:

      [...] to the latest weekly report from DRAMeXchange: The month-end inventory pressures have caused the spot price to slip further. Amid an anticipated DRAM price rebound, [...]

    Leave a Reply

    You must be logged in to post a comment.