How to Use Financial Reports to Determine Inventory Turnover

The big question you have for any company when examining financial reports is how quickly it sells its inventory and turns a profit. As long as a company turns over its inventory quickly, you probably won't find outdated products sitting on the shelves. But if the company's inventory moves slowly, you're more likely to find a problem in the valuation of its inventory.

You use a three-step process to find out how quickly product is moving out the door.

How to calculate inventory turnover

Here's the three-step formula for calculating a company's inventory turnover:

  1. Calculate the average inventory (the average number of units held in inventory).

    Beginning inventory + Ending inventory ÷ 2 = Average inventory

  2. Calculate the inventory turnover (the number of times inventory is completely sold out during the accounting period).

    Cost of goods sold ÷ Average inventory = Inventory turnover

  3. Calculate the number of days it takes for products to go through the inventory system, according to the accounting policies in the notes to the financial statements.

    365 ÷ Inventory turnover = Number of days to sell all inventory

In this calculation, you find out the number of days it takes the company to sell its entire inventory.

You can use Mattel's and Hasbro's 2012 income statements and balance sheets to show you how to calculate inventory turnover and the number of days it takes to sell that inventory. Both companies use the FIFO inventory system to value their inventory, according to the accounting policy in their notes to the financial statements.

Mattel

  1. Find the average inventory.

    Use the inventory on hand December 31, 2011, as the beginning inventory, and use the inventory remaining on December 21, 2012, as the ending inventory.

    $487,000,000 (Beginning inventory) + $465,057,000 (Ending inventory) ÷ 2 = $476,028,500 (Average inventory)

  2. Calculate the inventory turnover.

    You need the cost of goods sold figure on the 2012 income statement to calculate the inventory turnover.

    $3,011,684,000 (Cost of goods sold) ÷$476,028,500 (Average inventory) = 6.33 (Inventory turnover)

  3. Find the number of days it took for Mattel to sell out all its inventory.

    365 (Days) ÷ 6.33 (Inventory turnover) = 57.7

As an investor reading this report, you can assume that, on average, Mattel sells all inventory on hand every 57.7 days. Remember, though, that isn't true for every toy that Mattel makes. Popular toys may sell out, and new stock may be needed every month, whereas less popular toys may sit on the shelf for several months or more. This calculation gives you an average for all toys sold.

Hasbro

  1. Calculate the average inventory.

    Use the inventory on hand December 31, 2011, as the beginning inventory, and use the inventory remaining on December 21, 2012, as the ending inventory.

    $333,993,000 (Beginning inventory) + $316,049,000 (Ending inventory) ÷2 = $325,021,000 (Average inventory)

  2. Calculate the inventory turnover.

    To do so, use the cost of goods sold number on the 2012 income statement.

    $1,671,980,000 (Cost of goods sold) ÷$325,021,000 (Average inventory) = 5.14 (Inventory turnover)

  3. Find the number of days it took for Hasbro to sell off its inventory.

    365 (Days) ÷5.14 (Inventory turnover) = 70.95

So Hasbro sells its entire inventory every 71 days. Mattel is selling its toys faster.

What do the numbers mean?

Hasbro takes more than 71 days to sell all its inventory, and Mattel sells out every 57.7 days. Mattel turns over its inventory about six times a year, whereas Hasbro turns it over about five times per year. To judge how well both companies are doing, check the averages for the industry — you can do so online at Bizstats.

Start by clicking on the selection for industry financial benchmark reports. Input the annual sales number. Using the stats for Miscellaneous Manufacturing, you will find that 6.84 is the average inventory turnover ratio in the industry. So Mattel is slightly below average, at 6.33, and Hasbro, at only 5.14, has more room for improvement.

If the company you're evaluating has a slower than average inventory turnover, look for explanations in the management's discussion and analysis and the notes to the financial statements to find out why the company is performing worse than its competitors. If the rate is higher, look for explanations for that also; don't get excited until you know the reason. The better numbers may be because of a one-time inventory change.

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