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Ratio Analysis: Inventory Turnover

In industries such as retail, success depends on management's ability to make or buy the right amount of inventory and to move that inventory through the distribution system as quickly as possible.

Axel Tracy's book, "Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet," provided "Inventory Turnover" as the first of several efficiency ratios. He used the Merriam-Webster dictionary to define efficiency: "effective operation as measured by a comparison of production with cost (as in energy, time, and money)."


Taking that one step further, the more efficient a company is at turning raw materials or wholesale products into cash at the end of the sales cycle, the more efficient it is. And, in almost all cases, the more efficient a company is, the more profits it will deliver to its shareholders.

Note there are a couple of other names for the inventory turnover ratio, the best known of which are "Cost of Goods Sold" (COGS) and "Cost of Revenue." You may see these names in place of inventory turnover on financial statements.

Tracy defines inventory turnover this way: "This ratio measures how many times in a given period a business is able to sell its average level of inventory." The higher the number, the better, since every inventory turn produces revenue and earnings. Not mentioned in the book, but also of relevance, is the fact that more turnover should reduce the cost per unit of fixed assets.

To calculate inventory, use this formula:


"Inventory Turnover = Cost of Sales / ((Inventory at Start of Period + Inventory at End of Period) / 2)"



Alternatively, they use this formula at myaccountingcourse.com:

In using the latter formula (and both formulas produce the same result), average inventory is also calculated by adding inventory at the start and end of the period and dividing by two. Data for cost of sales or cost of goods sold come from the income statement, while the two inventory numbers come from the previous and current balance sheets.

GuruFocus offers a ratio called days [in] inventory, which is essentially the same as inventory turnover: Days inventory is found in the ratios section of the summary page; for example, here is the ratio for CVS Health (NYSE:CVS), highlighted in orange:

Days inventory for CVS is 30.04, or very close to one month. Dividing 365 by 30.4 equals 12.006, which means inventory turnover is 12 times per year. The two ratios are interchangeable for anyone prepared to do a quick arithmetic calculation.

Out of curiosity, I also checked the days inventory for Walgreens Boots Alliance (NASDAQ:WBA). It is 34.14, which is roughly 14% higher than that of CVS (30.04). All else being equal (which it rarely is), CVS is 14.4% more efficient than Walgreens in managing inventory.

If we also convert Walgreens Boots to inventory turnover, we get 10.6 (365 / 34.4). Comparatively, CVS turns over its inventory 12 times a year, while Walgreens Boots turns its inventory over only 10.6 times per year.

Looking into the CVS case more deeply, we click on the Days Inventory category on the GuruFocus summary page, which brings up a page devoted to this ratio. On that page, we find this chart, illustrating how the company has successfully improved its days inventory results:

There are a couple of general ways in which a company can improve its efficiency and its inventory turnover: it can improve its selling or its procurement efficiency. Tracy explained, "Either sales are increasing and the speed at which goods are leaving the shop floor is improving or perhaps procurement has become more accurate and inventory purchases represent what the market wants and less is being left on the shelves (even though the level of inventory purchases may be changing)."

Only managers and others inside a business are likely to know why the inventory turnover is improving or worsening. The change may be due to a marketing campaign that is working or not working, perhaps new sourcing strategies have been implemented or something else has changed. If two or more changes are happening at the same time, it may be difficult to determine which factor is responsible.

This is one of the drawbacks of the inventory turnover ratio: "A good economy generally lifts up all the boats in the ocean, and the reverse for a poor economy. Without knowing the particular operations and strategies of the company being analyzed it's difficult to know if it's good management or good luck."

To that, he added the components of inventory turnover are not connected to selling prices or gross profits. So while a company may have an amazing inventory turnover ratio, it may be less profitable than a competitor with a poor inventory turnover.

And this ratio is industry-specific, which means you can't compare the ratios of, say, car dealerships and grocery retailers. "Some industries simply sell their inventory quicker than others and will have a higher Inventory Turnover naturally," Tracy wrote.

Conclusion

The inventory turnover ratio, as outlined by Tracy in "Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet," is a measure of efficiency. It tells us how efficiently management performs in handling the flow of goods through its business process.

Higher turnover is usually better than lower turnover because higher means greater sales in a given period and that should lead to higher profits. However, we can't always assume that relationship as a given; since the ratio is not directly influenced by selling prices, a company with a higher ratio may not necessarily be more profitable than a company with a lower turnover.

For GuruFocus subscribers, the equivalent of inventory turnover is the days inventory ratio, which can be found on the summary page for covered stocks.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.