Lesson 5 of 7
Reading an inventory turnover ratio
A grocer turns stock over dozens of times a year and a jeweller a handful. No level is good across both, and the direction is worth more than the level.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The defensible version divides cost of revenue by average inventory, because both are stated at cost, while dividing revenue by inventory mixes a price flow with a cost balance.
- Two identical companies selling identical stock at different prices report different turnover on the revenue version and the same turnover on the cost version.
- Slowing inventory turnover is one of the earliest signs that products are not selling, and it often appears before margin does.
Inventory turnover is published two ways, and they are not variants of one measurement: cost of revenue divided by average inventory, or revenue divided by inventory. The first compares like with like. The second divides a selling-price flow by a cost balance, so the gross margin sits inside the result whether you wanted it there or not.
Same stock, same cost, two selling prices
- Turnover on cost of revenue, Company A7.0x
- Turnover on cost of revenue, Company B7.0x
- Turnover on revenue, Company A10.0x
- Turnover on revenue, Company B14.0x
Average or closing inventory
The numerator covers twelve months and the denominator is a balance on one day, so averaging the opening and closing balances is the better match, though most published figures use the closing balance alone because it needs only one balance sheet. In a flat year the two barely differ. In a year where stock grew or shrank a lot, or a mid-year acquisition added inventory the company owned for only part of the year, they differ considerably. Pick one convention and hold it across every year and company compared; a series that switches conventions has a break in it that looks like an operating change.
Two companies, same stock, different books
LIFO and FIFO are assumptions about which costs are assigned to what was sold. The physical stock is identical under both.
In a period of rising costs, the two conventions diverge on every figure that touches inventory.
FIFO
- Assigns the oldest, lowest costs to cost of revenue.
- Leaves the newest, highest costs on the balance sheet.
- Reports a lower cost of revenue and a wider gross margin.
LIFO
- Assigns the newest, highest costs to cost of revenue.
- Leaves the oldest, lowest costs on the balance sheet.
- Reports a higher cost of revenue, a thinner gross margin, and a lower inventory balance.
Turnover is cost of revenue over inventory, so LIFO raises the numerator and lowers the denominator at the same time. Neither difference is operational.
A LIFO company discloses a reserve: the gap between its LIFO carrying amount and what inventory would be under FIFO. Add the reserve to inventory, and subtract the year's increase in the reserve from cost of revenue; then both halves of the ratio are on FIFO. Until that is done the two companies are not comparable on this ratio, on gross margin, or on anything with inventory in it.
Penman's point applies: the cost-flow choice moves profit between years; the cash is the same. IFRS does not permit LIFO.
The direction is the signal
Slowing inventory turnover is one of the earliest quantitative signs that products are not selling, and it often appears before gross margin moves. Demand softens; stock builds because production was set against the older forecast; days of stock rise. The company then discounts to move it, and the discount reaches gross margin a quarter or two later. Inventory days lead gross margin, which is why reading them together tells you more than reading either alone. A rise in inventory days alongside flat revenue is the pattern worth noticing, because it says the build is not growth.
Check the cost-flow policy before the ratio
- Open Item 8 and read the significant accounting policies note for the inventory basis.
- If it says LIFO, find the reserve and add it back before comparing the company to anyone on FIFO.
- Compute turnover as cost of revenue over average inventory for five years, and write gross margin beside it for the same five years.
Check yourself
Two companies sell the same physical stock at the same cost but at different prices. Which turnover measure gives them the same number?
- Revenue divided by inventory
- Cost of revenue divided by average inventory
- Neither measure agrees between them
Show the answer
Answer: B.
The cost measure compares like with like, since inventory is carried at cost. The revenue measure mixes in the selling price, so it diverges even when the physical stock and cost are identical.A company switches from FIFO to LIFO in a period of rising costs. What happens to its reported inventory turnover?
- It falls, because inventory is understated
- It rises, because cost of revenue rises and the inventory balance falls at the same time
- It is unaffected, because turnover ignores the cost-flow method
Show the answer
Answer: B.
LIFO assigns the newest, highest costs to cost of revenue and leaves older, lower costs on the balance sheet, which raises the numerator and lowers the denominator together.Inventory days rise for two quarters while revenue stays flat and gross margin has not yet moved. What does this pattern typically precede?
- A rise in gross margin
- A discount that lowers gross margin a quarter or two later
- Nothing; the two measures are unrelated
Show the answer
Answer: B.
Rising inventory days ahead of flat revenue is an early sign that stock is not selling. The discounting used to clear it typically reaches gross margin with a lag.Sources
- Penman, Financial Statement Analysis and Security Valuation, on accounting rules shifting income between periods rather than into existence.
What this leaves out
- This lesson gives no target turnover level by industry, and none exists that survives the model differences described above. A company against its own history, on one convention, is the comparison that carries information.
- The ratio and its days version are withheld for companies holding no inventory, including most services and software businesses, and do not transfer to banks, insurers or REITs.
- The figure and the worked example use round invented inputs.
- Nothing here is advice about any security.