Inventory Turnover

What is inventory turnover?

Inventory turnover (German Lagerumschlag or Lagerumschlagshäufigkeit) indicates how often a company sells and replenishes its average stock of goods within a period, usually a year. An inventory turnover of 6 means that, arithmetically, the stock passes through the warehouse six times a year; each item therefore stays on average around two months before it is sold. A fishmonger who fills the counter fresh every morning and sells out by the evening turns over the stock once on each of around 300 trading days. A furniture store whose sofas stand in the showroom for three months on average reaches only about four turns a year. The higher the value, the less money is tied up in goods still waiting for buyers.

The metric belongs to retail, e-commerce and manufacturing. It is tracked monthly in controlling, presented in discussions with banks about credit lines, and recalculated in due diligence, in which investors or buyers examine the company before signing a contract. It is closely linked to working capital, the capital tied up in inventories and customer receivables in the ongoing business, less supplier liabilities. In the balance sheet, inventories are shown under current assets, which include the assets that are not intended to remain in the business permanently.

Calculating inventory turnover: formula and days in inventory

Formula: Inventory turnover = cost of goods sold divided by average inventory

Cost of goods sold (Wareneinsatz) is the cost value of the goods sold, that is, their purchase price including incidental acquisition costs such as freight and customs duties. Inventory is also stated at cost. If sales were divided by inventory instead, only the numerator would contain the retailer's mark-up on the purchase price (trade margin), and the turnover would appear too high. In manufacturing, material consumption or the production costs of the products sold take the place of cost of goods sold.

Average inventory

The simplest average is half of the opening and closing inventory of the year. It is imprecise if inventory fluctuates during the year. More precise is the mean of the opening inventory and the twelve month-end inventories, that is, of 13 values. For seasonal businesses the difference is considerable: if the financial year ends shortly after the Christmas trade, the warehouse is almost empty on the reporting date, and the turnover looks better than it was on the annual average.

Days in inventory

Days in inventory (Lagerdauer, days inventory outstanding, DIO) indicates how many days the goods stay in the warehouse on average.

Formula: Days in inventory = 365 divided by inventory turnover = average inventory divided by cost of goods sold × 365

Days in inventory is one of the three components of the cash conversion cycle, which measures the time between payment to suppliers and receipt of payment from the customer.

Tied-up capital and liquidity

Goods are paid for long before they are sold. With overseas suppliers, down payments on ordering are common, and transport times of several weeks are added. Every day of days in inventory therefore ties up liquidity: the tied-up capital equals the cost of goods sold per day times the days in inventory. In addition there are storage costs for space, staff, insurance, shrinkage and obsolescence.

For growing retailers an important rule follows: growth consumes liquidity even if every individual order is profitable, because inventory must be built up before the revenue. This build-up is financed from equity, through payment terms with suppliers or through an overdraft facility, that is, a credit line on the business account. A higher inventory turnover directly reduces this financing need.

Accounting for inventories under the HGB

Under Section 240 of the German Commercial Code (Handelsgesetzbuch, HGB), every merchant (Kaufmann) must prepare an inventory list (Inventar) at the end of each financial year, that is, record its assets by quantity and value. For inventories this is done by the stocktake (Inventur), the physical count. Section 241 HGB permits simplifications, for example a sample-based stocktake or a perpetual inventory system, in which stocks are continuously updated in the merchandise management system and checked spread across the year.

Inventories are valued at no more than their acquisition or production cost. For current assets, the strict lower-of-cost-or-market principle also applies under Section 253(4) HGB: if the value on the balance sheet date is lower, a write-down must be made even if the impairment is only temporary. For merchandise, the decisive figure is often the expected selling proceeds less the costs still to be incurred until sale. For goods that are hard to sell or obsolete, graduated discounts that rise with the time since the last sale or receipt are common in practice (discounts for slow-moving stock).

For tax purposes, a write-down to the lower going-concern value (Teilwert) under Section 6(1) No. 2 of the German Income Tax Act (EStG) is possible only in the case of an expected permanent impairment. In simplified terms, the Teilwert is the amount that an acquirer of the whole business would attribute to the goods. The commercial and tax balance sheets can therefore diverge. The accounting valuation in an individual case is a matter for tax advisers and, where applicable, the statutory auditor.

Inventory turnover in e-commerce

Online retailers move between two risks. Too little stock leads to stock-outs: items are sold out, customers order from other providers, and advertising runs into the void. Too much stock ties up capital and often ends in clearance sales with discounts, which reduce the gross margin. This is particularly clear for seasonal goods and fashion, whose value falls sharply after the end of the season.

A single overall metric is therefore not sufficient for steering. Inventory turnover is only meaningful by product group or item, supplemented by stock cover, that is, the number of days for which today's stock will last at expected sales. It looks forward, days in inventory looks back.

Relevance in due diligence

In due diligence, buyers and investors request an ageing analysis of inventories, which sorts every stock by time since the last receipt or sale. It shows old stock that is still carried in the balance sheet at full cost. Missing write-downs subsequently reduce earnings and thus the basis of the valuation. In addition, they check inventory differences, that is, deviations between counted and booked stock, whether inventories were valued by the same method every year and how returns are recorded.

In the purchase agreement, inventory affects the purchase price through working capital. The parties often set a normal level that the buyer receives with the company; deviations on the reporting date are settled through a working capital adjustment. If a seller reduces inventory shortly before the reporting date, its liquid funds do rise, but the advantage is largely offset again through this adjustment.

Worked example: inventory turnover of an online retailer

An online retailer has cost of goods sold of EUR 3,600,000 in the financial year. Inventory at cost is EUR 1,000,000 at the start of the year and EUR 800,000 at year end. Before the Christmas trade, inventory rises sharply; the mean of 13 monthly values is EUR 1,200,000.

• Simple average: (1,000,000 + 800,000) divided by 2 = EUR 900,000
• Turnover based on reporting-date values: 3,600,000 divided by 900,000 = 4.0; days in inventory 365 divided by 4.0 = around 91 days
• Turnover based on monthly values: 3,600,000 divided by 1,200,000 = 3.0; days in inventory 365 divided by 3.0 = around 122 days
• Target turnover of 4.0 based on monthly values: required average inventory 3,600,000 divided by 4 = EUR 900,000, liquidity released 1,200,000 minus 900,000 = EUR 300,000
• At assumed capital and storage costs of 10% of inventory value a year: 300,000 × 10% = EUR 30,000 saving annually
• Ageing analysis: goods with a cost value of EUR 150,000 have not been sold for more than twelve months; a discount of 50% gives a write-down requirement of EUR 75,000

The result means: the annual financial statement values suggest days in inventory of around three months, but in fact the goods stay on average around four months. If the turnover can be raised to 4.0, EUR 300,000 is released and is available for growth without new capital having to be raised. The ageing analysis also shows that part of the inventory no longer reaches its book value; a buyer would deduct the EUR 75,000 from earnings and from working capital.

Distinctions: inventory turnover, stock cover and working capital

• Stock cover: divides today's stock by expected daily sales and is used for order planning. Days in inventory, by contrast, measures the actual sales of the past. Both are stated in days and are therefore easily confused.
• Cash conversion cycle: combines days in inventory with the time until payment is received from the customer and the payment term with suppliers.
• Working capital: includes, besides inventories, also receivables and supplier liabilities. Inventory turnover explains only part of it.

Common mistakes

• Sales instead of cost of goods sold in the numerator. The metric rises by the trade margin and is no longer comparable with values of other companies.
• Reporting-date values for a seasonal business. An inventory shortly after the peak season understates the capital that is tied up over the course of the year.
• Average across the whole range. Fast-moving items conceal stock that has not moved for months.
• Write-downs postponed. Old stock at full cost improves earnings and equity only apparently and is corrected in the audit.
• Turnover at the expense of delivery capability. Anyone who cuts inventory too far loses revenue through stock-outs, which is not visible in the metric.

Frequently asked questions

What is a good inventory turnover?

There is no general benchmark. Foods with a short shelf life turn over much faster than furniture or spare parts. A high value means little tied-up capital; if it rises because stock is too tight, sales are lost. The comparison with the company's own development over several years and with companies that carry a similar range is meaningful.

Does a stocktake have to take place every year?

Yes, for every GmbH (German limited liability company) and every other merchant; only small sole traders under Section 241a HGB are exempt. The inventory list is to be prepared at the end of each financial year. With a perpetual inventory system, the physical count can be spread across the year if stocks are reliably updated.

Why does inventory turnover often fall in growth phases?

Because inventory is built up before the expected revenue. The cost of goods sold of past months does not yet reflect future sales. Investors therefore check whether the inventory build-up is backed by orders and sales planning.

How does a buyer recognise a need for write-downs?

Mainly through the ageing analysis and the sales after the reporting date. If old stock is sold only at high discounts or not at all, the book value is too high.

The Roemer Capital view

For clients in retail and e-commerce, Roemer Capital prepares days in inventory and the age structure of inventories before a funding round on the basis of monthly values and by product group. Because in these business models every growth step has to pre-finance an inventory build-up, days in inventory flows directly into the liquidity planning and into the capital requirement that the client raises in the round.

In a company sale, Roemer Capital shows the buyer the seasonal pattern of inventories early, so that the agreed normal working capital does not rest on an unfavourable reporting date. The accounting valuation of inventories remains with the client's tax adviser.