Inventory turnover can be a useful tool in evaluating retail-based businesses. It is expressed as an efficiency ratio that indicates how often a company’s inventory is sold and replaced over a given period of time. It can be calculated one of two ways: either by dividing market value of sales by ending inventory, or by dividing cost of goods sold (COGS) by average inventory. The second method is usually considered more accurate as it does not include markups and better accounts for seasonal variances. Always remember to compare like inventory turnover calculations. Inventory ratio is also a key component for determining return on assets (ROA).
Inventory turnover is almost always compared against industry averages. A grocery store, for instance, would be expected to have higher inventory turnover than a department store due to the perishability of its goods. In general, a low inventory turnover ratio means a business is performing poorly with weak sales and/or excessive inventory. A high inventory turnover ratio can mean good sales, but may be affected by discounts. Higher-than-average inventory turnover can also indicate that a business does not have an effective purchasing plan in place. Inventory turnover must be compared with profitability to see if a business is really performing well.