Asset turnover and inventory turnover

Turnover ratios measure efficiency: how many dollars of sales a company generates from each dollar of assets, or how quickly it sells through the stock it holds. A business that can do more with less capital tends to earn better returns, and falling turnover is often an early sign that something is going wrong, such as unsold goods piling up or assets not earning their keep.

Asset turnover

Asset turnover = Revenue / Average total assets

Revenue comes from the income statement and average total assets from the balance sheet, usually the mean of opening and closing balances. A result of 2.0 means the company generated $2 of sales for every $1 of assets.

Asset turnover is one of the three parts of the DuPont breakdown of return on equity, alongside net margin and leverage. It is also half of the identity behind return on assets:

ROA = Net margin x Asset turnover

This shows two broad routes to a good return. Some businesses earn a thin margin on very high volume, such as grocery retailers. Others earn a fat margin on lower volume, such as makers of specialized equipment or companies with large infrastructure investments. Neither is better in itself; what matters is the product.

Inventory turnover

Inventory turnover = Cost of goods sold / Average inventory

Days inventory outstanding = 365 / Inventory turnover

Inventory is valued at cost, so the matching income statement figure is cost of goods sold rather than revenue. Some data providers use revenue in the numerator, which gives a higher figure, so check which version you are looking at. Days inventory outstanding (DIO) converts the ratio into a number of days: how long, on average, an item sits in stock before it is sold.

Example (illustrative numbers)

A retailer reports the following for the year:

Asset turnover     = 2,000 / 1,000 = 2.0x
Inventory turnover = 1,200 / 200   = 6.0x
Days inventory     = 365 / 6       = about 61 days

The retailer sells through its inventory roughly six times a year, holding each item for about two months. If next year inventory turnover falls to 4.5x with no change in the business, days of inventory rise to about 81. Tying up more money in unsold goods means less cash for everything else, and possibly a looming need to cut prices.

How to read it

Turnover varies dramatically by industry, so comparisons only make sense among similar businesses:

What you want to see is stability or improvement over time and favorable comparison with direct peers. Some patterns to notice:

• Inventory growing faster than sales. This can mean weakening demand, a poor forecast, or a build-up ahead of an expected increase in sales. Management commentary and the notes to the filings should explain which. If inventory is growing quickly while sales are flat, the risk of write-downs rises.
• Asset turnover declining after acquisitions. Purchased assets, especially goodwill, expand the asset base without necessarily adding proportional revenue.
• Improving turnover with stable margins. This typically indicates better operations and feeds straight through to higher returns on capital.

Common mistakes and limits

Comparing across industries. A turnover of 1.0 is poor for a retailer and normal for a utility. Use peers.

Seasonality. A retailer's inventory is much larger before the holiday season than after. An average of only the opening and closing balances can mislead. Averaging the four quarter-end balances is more representative.

Mix and pricing effects. Turnover can improve simply because prices rose or because a company wrote down assets, shrinking the denominator. A better ratio does not always mean better operations.

Ignoring what the inventory is. Raw materials, work in progress and finished goods behave differently. A rise in finished goods unsold is more worrying than a rise in raw materials ahead of a price increase.

Treating high turnover as always good. Very high inventory turnover can also mean stockouts and lost sales, because the company is running too lean.

Overlooking accounting choices. The inventory valuation method, such as FIFO or LIFO, changes the carrying value during periods of changing prices and affects the ratio.

Linking turnover to cash

Inventory turnover is one component of the cash cycle, the number of days between paying for inputs and collecting from customers. Combining it with receivable and payable days gives the cash conversion cycle, which shows how efficiently the company handles its working capital. Margins then determine how much profit each turn produces. For margins, see gross, operating and net margin.

Where to see it on StocksXray

Turnover ratios are part of the wider picture of profitability and financial health, and should be read together with margins and leverage. The X-Ray Score gives 25% weight to profitability and 20% to financial health, with each metric ranked as a percentile within the company's own sector, so a grocer's turnover is judged against other grocers rather than against a software firm. The methodology page describes the approach.

Key takeaways

• Asset turnover is revenue divided by average assets; inventory turnover is cost of goods sold divided by average inventory.
• Days inventory outstanding is 365 divided by inventory turnover.
• ROA equals net margin times asset turnover, so a company can earn a good return through volume or through margin.
• Compare only within an industry, and use averages when the business is seasonal.
• Inventory growing faster than sales deserves a closer look at the filings.