This is considered to be an activity ratio since it measures how fast a company can sell its inventory. This is done by calculating the number of times inventory is sold during the period. The higher the ratio is, the more liquid the inventory and the less cash a company has invested in its inventory.
Example:
Adequate Disclosure, Inc. plans to invest into Inadequate Disclosure, Inc. The financial analysts decide that the inventory turnover is a great indicator to determine if Inadequate Disclosure, Inc. is worth an investment of $100,000. The industry average is around 1.7. Calculate the inventory turnover for Inadequate Disclosure, Inc.
The Formula is:
Cost of Goods Sold / Average Inventory (Beginning & Ending)
Cost of Goods Sold / (Beginning Inventory + Ending Inventory/ 2)
$987,000 / ($560,000 + $700,000/2) = $987,000/$630,000 = 1.56