How to Calculate Inventory Turnover/Turns From the Balance Sheet explained by professional Forex trading experts the “ForexSQ” FX trading team.
How to Calculate Inventory Turnover/Turns From the Balance Sheet
Now that you have a better idea of what the inventory on a balance sheet represents, I want to teach you how to calculate a financial ratiocalled inventory turnover, which is also known as inventory turn, because it can go a long way toward giving you insight into the efficiency, both absolute and relative, a company enjoys when going through the cash conversion cycle. For example, two competing companies may each have $20 million sitting in inventory, but if one can sell it all every 30 days, and the other takes 41 days, you have less of a risk of inventory loss with the 30-day company.
Additionally, the more rapid inventory turnover occurs, the higher the return on equity and return on assets, as well. This has to do with one of the variables in the so-called DuPont desegregation of return on equity, which is worth looking into if you want to become a better manager and investor but it ultimately means one thing and that is higher profitability.
The Formula for Calculating Inventory Turns/The Inventory Turnover Ratio
Cost of Goods Sold1 ÷ Average Inventory for the Period2
1: This is found on the income statement, not the balance sheet
2: Average inventory is calculated by taking the last period’s inventory plus the current period inventory and dividing them by two.
Examining a Real World Example: Looking at an Old Coca-Cola Balance Sheet
I’m always a fan of real-world illustrations because they seem more tangible in a way. At the bottom of the page, I’ve provided an older excerpt from the financial statements of Coca-Cola when I first wrote this lesson almost two decades ago.
Once I’ve walked you through it, I want you to go pull Coke’s most recent annual reportand 10-K filing so you can practice performing the same inventory turnover calculation with this year’s information. You’ll see the concept is timeless.
You see that the cost of goods sold was $6,204,000,000. The average inventory value between 1999 and 2000 was $1,071,000,000 (to discover this, you need to calculate the average of the values from 1999 and 2000 by summing them together then dividing by two).
Plug these numbers into the formula for inventory turn and you have your answer:
Current Year’s Cost of Goods Sold of $6,204,000,000 ÷ Average Inventories of $1,071,000,000 = 5.7927 inventory turnover
What this means is that Coca-Cola sold all of its inventory 5.79 times each year back between 1999 and 2000. Is this good? To answer this question, you must find out the average turn of Coke’s competitors and compare. If you do the research, you find out that the average turnover of a company in Coke’s industry was 8.4. Why was Coca-Cola’s turn rate lower? Should it have influenced your investing decision? The only way you could answer these kinds of questions is if you truly understood the business you are analyzing. This is why it is important that you read the financial statements and the disclosure notes that go along with them. Had you done so, you’d have discovered that, although Coke’s inventory turn rate was lower, it was 4x to 5x financially stronger than the industry averages. With such outstanding economics, you probably don’t need to worry about inventory losing value. It was a non-event.
Ordinarily, it’s useful to examine how the inventory turnover calculation changes for a company over a period of many years.
One of the benefits of using Coca-Cola in this illustration is that Coke has divested, acquired, and divested its bottling operations over the past couple of decades, resulting in big changes to the inventory turn ratio. On paper, that should have raised your eyebrows and justified a much closer look. Long-term, it hasn’t mattered because both Coca-Cola and its primary rival, PepsiCo, have been among the best investments in history due to their extremely high returns on invested capital.
Using Inventory Turnover to Calculate Average Days to Sell a Product
Let’s take the inventory analysis a step further. Once you have the inventory turn rate, calculating the number of days it takes for a business to clear its inventory only takes a few seconds. Since there 365 days in a year and the Coca-Cola was clearing its inventory 5.7927 times per year, we would have taken 365 ÷ 5.7927.
The answer (63.03) was the number of days it takes for Coke to go through its inventory. This is a great trick to use at cocktail parties; grab a copy of an annual report, scribble the formula down and announce loudly that “Wow! This company takes 63 days to sell through its inventory!” People will instantly think you are an accounting whiz. Or they’ll just think you’re weird. But, hey … it’s still useful.
What Is a Normal Inventory Turnover Ratio?
The number of days a company should be able to sell through its inventory varies greatly by industry. Retail stores and grocery chains are going to have a much higher inventory turn rate since they are selling products that generally range between $1 and $50 and that spoil quickly, requiring far greater managerial diligence. Companies that manufacture heavy machinery, such as airplanes, are going to have a much lower turnover rate since each of their products may sell for millions of dollars and take an extended period of time to produce. Hardware companies may only turn their inventory 3 or 4 times a year, while a department store may do twice that, turning at 6 or 7.
To repeat what I’ve already told you, this is the reason it can be a useful exercise is to compare the inventory turnover rate of a potential investment against that of its competitors to see which management team is more efficient.
Inventory in Relation to Current Assets
When analyzing a balance sheet, you also want to look at the percentage of current assets inventory represents. If 70 percent of a company’s current assets are tied up in inventory and the business does not have a relatively low turn rate (less than 30 days), it may be a signal that something is seriously wrong and an inventory write-down is unavoidable.
* It is acceptable to use the total sales instead of the cost of sales when calculating inventory turnover ratios. The cost of sales is a more accurate reflection of inventory turn and should be used for the truest results. When comparing the company to others in its industry, make sure you use the same number. You cannot value one company using cost of sales, and another using total sales or else you will end up with faulty data.
Calculating Inventory Turn Ratio Data
As explained in the text, learning how to calculate inventory turn is a matter of knowing which numbers go in which place in the formula. To demonstrate the calculation, we’re using the original figures from 1999 and 2000, which were the most recently available figures when I originally wrote this article back in 2001, almost two decades ago. While it isn’t necessary to have recent figures — the point is not to understand The Coca-Cola Company but to learn how to calculate a specific financial ratio — it could be good practice for you to track down a recent annual report or 10-K filing for Coke and try this exercise with the data from the past two years.
|Coca-Cola Financial Statement Excerpt|
|Inventory on Balance Sheet||$1,066,000,000||$1,076,000,000|
|Cost of Goods Sold on Income Statement||$6,204,000,000|
How to Calculate Inventory Turnover/Turns From the Balance Sheet Conclusion
For more information about currency trading brokers visit TopForexBrokers.com Forex brokers comparison website, Tip ForexSQ.com foreign exchange trading experts please by share this article about How to Calculate Inventory Turnover/Turns From the Balance Sheet.