The inventory turnover ratio, also known as inventory turn, tells an investor how often a company sells through its inventory. Generally, the faster inventory is turned, the less risk of loss and the more efficient management is handling capital.
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.
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.
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.
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.
* 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|