How to Use the Inventory Turnover Liquidity Metrics
The number of times a company’s inventory is sold and replenished is called the inventory turnover. Here, the term turnover means that the total value of a company’s inventory has been completely depleted and recovered. A high number means that the company cycles through its inventory very quickly, while a low number means that the inventory cycles very slowly.
You calculate this magical value by using the following equation:
Follow these steps to put this metric to use:
Find cost of goods sold in the revenue portion of the income statement.
Use the balance sheets from the current year and the previous year to find average inventory: Add the two inventory values together (find them in the assets section of the income statement) and divide the total by 2.
Divide cost of goods sold by the answer from Step 2 to get the inventory turnover.
When a company makes a lot of a single product, it wants to have an idea of how long it will take to sell the entire quantity of that product.
Knowing this can help the company estimate how quickly it will make money to pay off its bills and how much money it should spend on making more inventory so it doesn’t have too much inventory or, even worse, run out altogether. Believe it or not, selling something you don’t have is quite difficult, as is buying more supplies if you can’t sell what you’ve already made.
To avoid both of these mistakes, companies can use the inventory turnover in days metric:
Here’s how to use this equation:
Use the balance sheets from the current year and the previous year to find average inventory: Add the two inventory values together (find them in the assets section) and divide the total by 2.
Find the cost of goods sold in the revenue section of the income statement.
Divide cost of goods sold by 365.
Divide the answer from Step 1 by the answer from Step 3 to get the inventory turnover in days.