An inventory turnover ratio is a standard financial calculation that determines the number of times a business replaces its inventory to generate its current level of sales over a given time period, typically 12 months. The formal calculation is the cost of goods sold (COGS) during the year divided by the average investment in the company's inventory. Average inventory is calculated by adding the value of the company's beginning and ending inventory for the year and dividing it by two. The inventory turnover ratio enables a company to properly manage its inventory levels and to determine how much of its cash should be tied up in inventory at any one time.
Managing a business involves a complex assessment of how best to use resources on hand to assure stability and growth. A wrong decision can quickly lead to the end of a business. Lack of liquidity means the business cannot react to opportunities in the marketplace or position itself to grow its marketshare and increase revenue.
One of the key elements of resource allocation is inventory management. Inventory tends to be a company's single biggest investment. The calculation of a company's inventory turnover ratio allows it to understand how much inventory should be sitting on the shelf at any particular time throughout the year. If the company buys all of its inventory needs at the beginning of the year and slowly sells it off during the course of the year, its inventory turnover rate would equal one. While this seems like a productive way to manage inventory by paying for all needs at the beginning of the year, it actually hurts the business by tying up cash in inventory that might not sell until the end of the year.
The better course of action is to determine the smallest amount of inventory the business needs to keep on hand and the number of times it would have to replenish its stock during the course of the year to generate the same revenue as purchasing all of the inventory at the beginning. This is where the inventory turnover ratio comes into play. The ratio takes the COGS and divides it by the average inventory investment for the year. Thus, the formula enables the company to determine the greatest number of inventory turnovers it can withstand during a year and still reach a desired income level.
With the inventory turnover ratio, a company can determine it can turnover its inventory four times a year and still reach the same income levels as it would if it purchased all inventory upfront, for example. Operationally, this means the company would only have to spend one-fourth of its inventory budget at the beginning of the year. This frees up working capital for the company to pursue other initiatives instead of having cash sitting on shelves in the stockroom.