The inventory turnover ratio indicates how many times the inventory is converted into sales in one year.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Company ABC has an average inventory of Rs 100 Cr and Sales of Rs 500 Cr. The cost of goods sold is Rs 200 Cr. (Cost of goods sold refers to, direct cost incurred in producing the end product. In our case to simplify, the company produced the product with the cost (or expenses) of Rs 200 Cr and sold that product for Rs 500 Cr).
The inventory turnover ratio is 2 (200 / 100). This means the company is able to convert the inventory into sales 2 times a year or once in 6 months.
How to use practically
Inventory is the finished goods which the company maintains in its warehouse and showroom to sell it to the respective customer.
If a company is selling very popular products, then the goods in the inventory get cleared rapidly and easily. This means the company has a high inventory turnover ratio.
If you are selling milk on day to day basis in your locality, and you know that you will at least sell 5 Litres of milk every day, then you will keep an inventory of milk of 5 L and some extra milk in case of a sudden demand for milk, which means you will be able to sell milk very easily and convert inventory of milk into sales very quickly. This process is captured in the inventory turnover ratio.
If you are able to sell your milk very easily and convert it into sales, this ratio will be higher.
But this is not true in every business, for example, you are a bike/motorcycle manufacturer, selling bikes every day is not easy as selling milk. This means you will be having a low inventory turnover ratio.
Having a high turnover ratio is a very good sign that, the company is able to convert its inventory into sales very easily and this ratio has to be compared with its peer groups in the same industries to get a better understanding of the business.
It is necessary to see the trend of inventory turnover ratio to know how well the management is managing its inventories.