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√ Reality Check –
Computing Inventory Turnover
Average Inventory Inventory Turnover= COGS
( 1 , 060 , 164 1 , 214 , 622 )/ 2
1 , 172 , 646 = + = 1. 03
Hint : See page 5-7 for financial statement data.
Inventory Turnover
The inventory turnover ratio is a common measure of the firm’s operational efficiency in the management of its assets. As noted earlier, minimizing inventory holdings reduces overhead costs and, hence, improves the profitability performance of the enterprise. Ideally the inventory turnover ratio would be calculated as units sold divided by units on hand. However, the financial statements themselves will only capture monetary valuations and hence external evaluation of inventory turnover must rely on the valuation metrics recorded under GAAP, namely:
While it is theoretically superior to average the “snapshot” balance sheet amounts of inventory in order to benchmark Cost of Goods Sold for the entire year, some analysts simply utilize the ending inventory number for computational expediency – a minor inaccuracy for firms with relatively static year-to-year inventory levels.
The inventory turnover ratio is often interpreted as a measure of the number of times that the company sold through its inventory during the year. Thus, for example, an inventory turnover ratio of 4.0 indicates that the company sells through its stock of inventory each quarter – in other words, there is a three month supply of inventory on
Inventory Turnover
( BeginningInventory EndingInventory)/
CostofGoodsSold AverageInventory
CostofGoodsSold = +
Days Sales in Inventory
( ) AverageDailySalesatCost
AverageInventory CostofGoodsSold/
AverageInventory InventoryTurnover
(^360) = =
hand. Indeed, the inventory turnover ratio is often inverted and multiplied by 360 to estimate the number of days sales sitting in inventory:
The inventory turnover ratio is often misestimated due to two computational flaws that are all too common even among publicly available online databases purporting to calculate reliable sets of financial performance ratios. These are:
- Utilizing Sales Revenue rather than Cost of Goods Sold in the numerator.
- Failing to account for the off-balance sheet LIFO Reserve in the denominator.
Both computational defects result in an overstatement of the true inventory turnover performance of the firm. Sales Revenue is measured at the selling price of the units sold while the Inventory numbers in the denominator are measured at cost. Thus,
Inventory Turnover Comparisons
(^5 3 )
73
5 3 7 5 1 8 0
10
20
30
40
50
60
70
80
3m
Abercrombie & Fitch
Borders Dell Home DepotMedtronicParker Hannifin Procter & Gamble
Tiffany & CoWal-Mart Stores
Figure 5.
Inventory Turns Per Year
Inventory Turnover Comparisons
(^5 3 )
73
5 3 7 5 1 8 0
10
20
30
40
50
60
70
80
3m
Abercrombie & Fitch
Borders Dell Home DepotMedtronicParker Hannifin Procter & Gamble
Tiffany & CoWal-Mart Stores
Figure 5.
Inventory Turns Per Year
Olin’s reported inventory turnover rate of 11.97 is, on its face, impressively high
- especially when compared to those of other manufacturing companies illustrated in Figure 5.6 on page 5-27. However, it was computed using both Sales Revenue in the numerator and the balance sheet LIFO Inventory amounts in the denominator:
Inventory Turnover=EndingSalesInventory=^3263 ,^151. 3.^8 = 11. 97
A far more accurate measure of true inventory turnover (in units) would utilize the Cost of Goods Sold in the numerator and measure Inventory at its current cost (i.e., by adding back the off-balance sheet LIFO reserve). Making these adjustments cuts the measurement of the inventory turnover ratio by a factor of 3 and brings Olin much more in line with typical manufacturing firms:
Inventory Turnover=EndingCostInventoryofGoods+LIFOSoldReserve= 2632 ., 3823 + 426.^0. 7 =^2690 ,^823. 0.^0 = 4. 09
