Inventory Turnover
Inventory turnover tells you how fast a company sells its stuff. Higher turnover = selling faster = less cash tied up in inventory sitting on shelves.
Definition
Inventory turnover measures how many times a company sells and replaces its inventory over a period. A higher ratio indicates efficient inventory management — the company is selling goods quickly. It is a key efficiency metric for manufacturing, retail, and distribution businesses.
Formula
Inventory Turnover = COGS / Average Inventory
COGS
Cost of goods sold for the period (from income statement)
Average Inventory
(Beginning inventory + ending inventory) / 2 (from balance sheet)
Cash Conversion Cycle
How long it takes to turn inventory into cash
DIO (30) + DSO (45) - DPO (35) = 40 days. This means the company needs to fund 40 days of operations before cash comes back in. Lower is better — it means less cash tied up in the cycle.
Interpreting Inventory Turnover
Higher turnover means the company converts inventory to sales more quickly, tying up less cash. Grocery stores might turn over inventory 14x/year (every 26 days), while luxury goods makers might turn 2x/year. Always compare to industry peers — there is no universal 'good' number. Days Inventory Outstanding (DIO) = 365 / Inventory Turnover gives the number of days inventory sits before being sold.
Cash Flow Implications
Inventory is cash that has been converted into physical goods. Rising inventory is a cash outflow (use of cash) in the working capital section of the cash flow statement. Companies that can maintain or reduce inventory levels while growing revenue generate superior free cash flow. Just-in-time inventory systems aim to minimize inventory holding costs.
Red Flags and Trends
Declining inventory turnover (or rising DIO) can signal: slowing demand, overproduction, or obsolescence risk. In retail, excess inventory often leads to markdowns that compress margins. In due diligence, analyze inventory by category (raw materials, WIP, finished goods) and compare aging to historical norms. Write-downs of obsolete inventory hit COGS and reduce margins.
Worked Example — With Real Numbers
A retailer has COGS of $500M, beginning inventory of $80M, and ending inventory of $100M. Average inventory = $90M. Inventory turnover = $500M / $90M = 5.6x. DIO = 365 / 5.6 = 65 days. If last year's turnover was 6.5x (56 days), the slowdown signals potential demand weakness or excess purchasing.
Key Takeaways
Higher inventory turnover means more efficient inventory management and less cash tied up
DIO = 365 / Inventory Turnover — converts the ratio into days for easier interpretation
Always compare inventory turnover to industry peers, not across industries
Declining turnover is a red flag for slowing demand or obsolescence risk
Common Mistakes in Interviews
Using revenue instead of COGS in the formula — inventory is carried at cost, so COGS is the correct numerator
Comparing turnover across industries with fundamentally different inventory characteristics
Not investigating the composition of inventory (raw materials vs. finished goods) when turnover declines
How Interviewers Test This
If asked about inventory's impact on cash flow: 'An increase in inventory is a cash outflow because the company has spent cash on goods it hasn't sold yet. This reduces free cash flow and is captured in the working capital adjustment.'
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