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hello friends my name is dhiraj vader from wallstreetmojo.com this is part 10 of our ratio analysis video series and in this installment we learn all about inventory turnover ratios in simple terms inventory turnover ratios help in measuring the efficiency of the company with respect to managing its inventory stock in order to generate sales so in this tutorial we basically have four objectives number one understand what inventory turnover ratio means number two what this formula and the calculations number three look at inventory turnover ratios of colgate calculated in excel and number four is basically its interpretations so before we jump into the tutorial a quick reminder for you we will be needing all the working files of colgate case study for this video so if you haven't downloaded it yet please do so from the description link below and also to keep yourself updated with the investment banking and core finance concepts please do subscribe to our channel wallstreetmojo so let's get started [Music] what is inventory turnover ratios inventory turnover ratios is a part of the ratio analysis framework and it comes under the category of turnover ratios turnover ratios is used to understand how the assets of the company are how efficiently the assets of the company is used to generate sales so within this category there are sub categories we have discussed the receivables turnover we also discussed the days receivables in our previous videos now we'll discuss what is the inventory turnover ratio inventory turnover ratio basically tries to understand how efficiently the inventory of a company is used utilized to generate sales so um now this was the literal meaning now think of the inventory right you know when you as a company purchase inventory that would be like a raw material inventory right so you might work on it to process and make it as a final product so the work in progress inventory is the part where you are working on that raw material inventory and then there will be a finished goods inventory where the product is ready in the final stages where you can actually sell it to the customers so uh generally the company takes a lot of time to purchase you know work in progress and take it to the finished goods right and after the finished goods there would be a selling process so all of this takes time right so inventory turnover ratios actually helps us understand how much time or how efficiently the inventory is being used to convert into finished goods and then from the finished goods to sales so that's that's the literal meaning of inventory turnover ratios how do you calculate the inventory turnover ratios let us see in the formula so here is the formula of inventory turnover ratio the formula is fairly simple in the numerator is the cost of goods sold and you divided by the average inventories so average inventory is nothing but the beginning inventory and the ending inventory so the inventory at the start of the year inventory at the end of the year and you add it up and divide it by two so that's how you know the inventory turnover ratio formula is defined as let's calculate the inventory turnover ratio with the help of an example uh we'll use a hypothetical example first and then we'll move on to calculating inventory turnover ratio for coal gate so let's assume that the cost of goods sold or cogs is that's a dollar sixty thousand for a company okay and the beginning inventory is dollar forty thousand and the ending inventory is dollar 20 000 so what will be the average inventory average inventory will be 40 000 plus twenty thousand divided by two so i can as well use this formula which is the average formula and what we'll get is uh thirty thousand as the average inventory okay so we have the cost of goods sold we also have the average inventory so we can find the inventory turnover ratio fairly simple this will be equal to cost of goods sold is 60 000 divided by 30 000 so we get the inventory turnover ratio as 2.0 so my question to you is that what does this signify you know think of it like what does 2 means to you right this basically means that a company is able to purchase the raw material work in progress make it as a finish good and sell it and this is what they are doing and they are doing it two times during the year and so if you look at the worth the literal meaning of inventory turnover ratio as 2.0 means that on an average the company is able to process the inventory how much amount of inventory this dollar 30 000 worth of inventory two times during the year so what is the whole meaning of processing the inventory the processing of the inventory means that you purchase the raw material work it goes through the work in progress and then it becomes a final product and then you sell it right so after selling of that product you know whatever the raw material cost and the essential associated cost you know those will be classified as cost of goods sold right so if the cost of goods sold is 60 000 and average inventory is 30 000 this means this cycle of processing to selling process has to take it has to be initiated two times during the year then only the cost of goods sold can become 60 000 right so i hope you understood the literal meaning of inventory turnover ratios now uh let me ask you another question how about this inventory of 2.0 is it good or bad you know is it good or bad the answer actually is it depends on the industry so it depends on the industry if the inventory turnover ratio is 2.0 has to be good then which industry it is from you know these now let me ask you another question whether this invented turnover ratio of 2.0 whether it is good or bad see the answer lies in the industry it is all about so what do i mean by the industry let's say if you are looking at a company which is into retail okay retail or merchandising you know fashion merchandise okay so what happens within this industry you know whatever inventory that you hold you cannot hold it for a very very long time you can't you know keep it forever right you have to sell it pretty quickly because if you don't then they may become obsolete so industries like merchandising or retail you know they they have an inventory turnover ratio of usually 5 to 10 okay and this is the typical ratio of retail and merchandising now think of another let's let's discuss about fast food mcdonald's how much do you think will be the inventory turnover ratio of mcdonald's what is the inventory for mcdonald's inventory would be of course the raw material is the food right the raw potatoes and the chicken and burgers and things like that so can they keep it for a long time can they keep it for five days six days seven days no they can't do that you know every time they have to they buy this raw material they have to immediately process it or you know they would try to minimize the holding time of you know this food because the food is as such a perishable product so they can't keep it for a longer time mcdonald's as such has a very high inventory turnover ratios because of the said reasons and if you calculate this it comes out to be around 300 plus higher if i remember correctly it's a very high inventory turnover ratio for mcdonald's likewise for restaurants and others where inventory cannot be kept for a longer time i think for restaurants usually it is around 20 times okay so as i said it depends on the industry whether it is good or bad on one side we saw an example of retail merchandising mcdonald's and other restaurants now there could be cases where inventory turnover ratios are very very small you know it could be as small as two or less than two as well and that depends on the industry you know how long the inventory takes so think of uh large manufacturing companies you know manufacturing of turbines manufacturing of cars you know all of these usually take a lot of time for processing okay so so think of manufacturing as such so with this understanding of inventory turnover ratios let's move to the balance sheet and calculate colgate's inventory turnover ratio so let's move to this row number 108 okay so this is where we are going to calculate the inventory turnover ratio so what all things is required for inventory turnover ratio we require the cost of goods sold and we require the average inventory so since this is a balance sheet we'll get the average inventory on the top and for the cost of goods sold we will actually link it from the income statement we are doing the linking only for the reason that it's fairly easy for us to you know do the calculations here within this sheet okay so the first step i will actually link it to the cost of goods sold from the income statement so here we have the cost of sales or the cost of goods sold that is 6072 for december 16. okay so i am linking this first right for all the years and now we will calculate the inventory turnover ratio here okay so for the first year we can't do so because we need the average figures uh but we'll start it from december 2017. for this we required the formula cost of goods sold divided by average inventory so this inventory turnover ratio is equal to cost of goods sold divided by average of the two years right so december 2016 and 17. so i'll scroll up and these are the two years starting and ending so let's do the average and enter so what do we get here we get 5.16 as the inventory turnover ratio of cool date for december 2017 okay so we can copy and paste this formula to note the trends in the inventory turnover ratio so what do you see we see that the inventory turnover ratio is decreasing year over year it was 5.16 and now it is 4.20 so what does this mean uh this means essentially that you know colgate's inventory is uh is taking a bit longer to process and convert into finished goods and finally into sales earlier they were doing processing the inventory 5.16 times during a year but now they are doing it only for 4.20 so whether it is good or bad you know we can we need to look at the industry peers etc to say you know whether this is a good position or not but just to give an example you know procter gamble inventory turnover ratio is somewhere around seven to eight times okay as compared to procter gamble colgate might not be doing very good so that's that's the kind of interpretation that you can deduct from its calculations i hope you understood the inventory turnover ratio and how it is calculated its interpretation and how it's simply applied on colgate just to give an example if you consider procter and gamble a procter gamble's inventory turnover ratio is around 13.5 now look at 13.5 of procter gamble versus 4.20 obviously 4.20 is very small as compared to doctrine gambles of 13.5 so almost three times the inventory is being processed by procter gambles almost at a three times speed of what colgate is doing currently so this is the kind of interpretation you can have when you start comparing inventory turnovers with its peers so i hope you understood what is inventory turnover ratio how it is calculated its interpretation as well as how you know we did the calculations with respect to colgate case study i hope you found this video to be useful please do like and share and if you have any feedback want to suggest a topic for any future video then you may do so by writing about it in the comments section also we come up with interesting videos on investment banking and core finance topics regularly so if you haven't subscribed to our channel yet please do so by clicking on the subscribe button below so that you can get the notification about our latest videos i hope you enjoyed the video have a nice day