## Inventory Turnover

One of the most frequently used but least understood measures of asset management is inventory turnover. The confusion around this measure can be attributed to the traditional definition of the term, which is the number of times in a year (or quarter) that a company "turns over" inventory. When an explanation does nothing more than rearrange the composition of the term itself, confusion and misunderstanding will reign.

It is important to understand that inventory turnover is a relative figure, in this instance to cost of goods sold (COGS) (as a function of sales growth). With COGS as the numerator and average inventory the denominator, the ratio states that with a given inventory level, a company is able to produce finished goods, execute sales and repeat the entire process X number of times during the period being measured. In other words, the company completes the days of inventory (DOI) cycle X number of times during the year. Taken from a different angle, NikoTech's Y2 inventory to sales ratio would infer that in order to generate $1.698 billion in net sales, the company needs $660 million in inventory. The question (now rhetorical) for NikoTech's management is to determine whether the veracity of that statement is beyond reproach or if improvements could be sought in both of the equation's variables.

Similar to the question that arose during the DOI calculation, one may be compelled to ask why, if inventory utilization is really a function of net sales, is COGS, and not the sales figure, the numerator in the equation? Bearing in mind that the only way to improve this ratio is to increase the numerator, decrease the denominator or both, it should be obvious that by using the sales figure, the result of the exercise would be unjustifiably inflated.

This point was first elaborated upon in the study of the DOI calculation, and the same implications for the balance sheet are found in the analysis of inventory turnover. Consistent with what was uncovered in the section on DOI, use of the net sales figures would artificially augment the numerator, thus disguising the true utilization of inventories. Recalling that the value of inventories on the balance sheet is the cost of the goods and that inventory values are transferred to the income statement as COGS, an accurate representation of inventory turnover requires use of this number.

If in the case of inventory turnover it is desirable to either increase the numerator or reduce the denominator, NikoTech finds itself in the same dangerous position it did when calculating the operating cycle. If the COGS number is increasing as a function of sales growth, either at the same or a slower pace than sales, then the numerator is a valid number. If, however, the number is growing in part due to issues not related directly to sales, the outcome of the calculation will misrepresent reality and inflate the turnover calculation. With this caveat in mind, one can determine NikoTech's inventory turnover ratio in both Y1 and Y2.

Based on COGS and inventory levels in Y1, Table 13.6 shows that NikoTech was able to produce finished goods, sell them and repeat the process 2.06 times in a 12-month period. All variables remaining equal and untouched, management is saying that in order to generate $1.440 billion in net sales, the company has to carry $480 million in inventory. The situation worsened in Y2, with a turnover figure of less than 2 (1.9). At that level, NikoTech needed to have $660 million in inventories to support $1.698 billion in net sales.

## Table 13.6: Y1 and Y2 Inventory Turnover

Y1 | Y2 | |
---|---|---|

Inventory Turnover | 2.06 | 1.9 |

By now, it should be intuitively obvious that the inventory turnover ratio is closely related to the DOI calculation. Actually, they not only are related but are identical. The only distinction between the two is that they use different methodologies to express the exact same concept. To prove this point, consider Table 13.7. In Y1, NikoTech's DOI and inventory turnover were 177 and 2.06, respectively. If one were to multiply 177 by 2.06, the product would be 365, or the number of days in a calendar year. Although a simple calculation, both the DOI and inventory turnover numbers are validated at this time. The same exercise can be completed for Y2, where the product of 194 and 1.9 is 365.

## Table 13.7: Days of Inventory Versus Inventory Turnover

Y1 | Y2 | |
---|---|---|

Days of Inventory | 177 | 194 |

Inventory Turnover | 2.06 | 1.9 |

Product | 365 | 365 |

When understood in relative terms, and taken in conjunction with other asset-related measurements, the inventory turnover tool is very valuable. If anything, it is another way to isolate the impact of inventory levels on the financial performance of an organization. Based on similar concepts, equal benefit can be gained from the accounts receivable and accounts payable turnover calculations.