Before you invest, you are going to have to make an informed decision about how much you think the inventory on the balance sheet is really worth. A major part of this decision should be based on how fast the inventory is "turned" (or sold). 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.
Finding out how fast a company turns its inventory is simple. Here's the formula.
Calculating Inventory Turns / Inventory Turnover RatioCost 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.
Real World Example of Inventory Turns / Inventory TurnoverLet's look at a real world example. At the bottom on the page, I've provided an older excerpt from the financial statements of Coca-Cola. The cost of goods sold is $6,204,000,000. The average inventory value between 1999 and 2000 is $1,071,000,000 (average the values from 1999 and 2000). Plug them into the formula for inventory turn.
Current Year's Cost of Goods Sold of $6,204,000,000 ÷ Average Inventories of $1,071,000,000
The answer is the number of inventory turns - in Coca-Cola's case, 5.7927. What this means is that Coca Cola sells all of its inventory 5.79 times each year. 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 is 8.4. Why is Coca-Cola's turn rate lower? Should it affect your investing decision? The only way you can answer these kinds of questions is if you truly understand the business you are analyzing. This is why it is important that you read the entire annual report, 10K and 10Q of the companies you have taken an interest in. Although Coke's turn rate is lower, further analysis of the balance sheet will reveal that it is 4 to 5x financially stronger than its industry averages. With such outstanding economics, you probably don't need to worry about inventory losing value.
Using Inventory Turnover to Calculate Average Days to Sell a ProductLet'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 clears its inventory 5.7927 times per year, take 365 ÷ 5.7927. The answer (63.03) is 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 investing genius.
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. Companies that manufacture heavy machinery such as airplanes, are going to have a much lower turn over rate since each of their products may sell for millions of dollars. 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.
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 AssetsWhen analyzing a balance sheet, you also want to look at the percentage of current assets inventory represents. If 70% 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.
This page is part of Investing Lesson 3 - Understanding the Balance Sheet. To go back to the beginning, see the Table of Contents. If you have already read this lesson, you can skip directly to the Balance Sheet Quiz.
Calculating Inventory Turn Ratio Data
|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|