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.
The 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.
By 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: