4. Activity: Inventory

INVENTORY TURNOVER

Inventory turnvoer indicates how frequently a firm replaces its inventory during a specific accounting period. It is therefore an indicator of how efficiently a firm manages its inventory.

  • A high inventory turnover ratio implies that the firm manages its inventory efficiently. By doing so, it limits the amount of capital that is tied up in the inventory.
  • A low inventory turnover ratio, in contrast, implies that the firm has a lot of capital tied up in the inventory. This capital might not be invested very efficiently.

The most common way to compute a firm's inventory turnover ratio is to divide the COGS during an accounting period by the average inventory during that period:

 

Inventory turnover = \( \frac{COGS}{\text{Average inventory}} \).

 

Turning again to Hershey's financials in 2015, we know from the firm's balance sheets and income statement (in millions of USD):

  • COGS in 2015: 4'004
  • Inventory beginning of 2015 (end of 2014): 801
  • Inventory end of 2015: 751

The numbers imply that Hershey's average inventory during 2015 was 776:

 

Average inventory = \( \frac{Inventory_{2014} + Inventory_{2015} }{2} = \frac{801+751}{2} \)= 776.

 

Hence, the firm's inventory turnover was 5.2:

 

Inventory turnover = \( \frac{COGS}{\text{Average inventory}} = \frac{4'004}{776} \) = 5.2.

  

Put differently, the firm sold its average inventory 5.2 times in 2015.

 

Again, a more intuitive way is to translate this turnover frequency into a turnover time. This will yield the so-called days inventory oustanding.

 

DAYS INVENTORY OUTSTANDING

The Days Inventory Outstanding (DIO), often also called Days Sales on Inventory, DSI) indicate for how many days, on average, the firm can supply its sales from inventory. The longer the DIO, the larger the firm's inventory (the less dependent the firm on its suppliers).

  

Formally, DIO is computed as follows:

 

DIO = \( \frac{\text{Average Inventory}}{COGS} \times 365 \).

 

Alternatively, we find DIO by dividing 365 by the firm's inventory turnover: 

 

DIO = \( \frac{365}{\text{Inventory turnover}} \).

 

In the case of Hershey, we found an inventory turnover of 5.2. This means that that the firm can support its sales for 70.2 days from inventory, on average:

 

DIO = \( \frac{365}{\text{Inventory turnover}} = \frac{365}{5.2} \)= 70.2 days.

 
Consequently, a considerable amount capital is tied up in the firm's inventory.

 

Now suppose the firm wanted to reduce its inventory such that it can support sales for only 30 days (instead of 70.2 days). How much capital would that free (assuming COGS would not change)?

By rearranging the first equation to compute DIO, we find:

 

Average inventory = \( \frac{COGS}{365} \times DIO \).

 

Plugging Hershey's values into this expression, we find that a 30 days of sales on inventory would imply an average inventory of 329 million:

 

Average inventory = \( \frac{4004}{365} \times 30 \) = 329.

 

Consequently, the firm would be able to reduce its inventory by 447 million, on average (= 776 - 329). Put differently, it could free 447 million of capital that is tied up in the inventory and redirect that capital to more productive uses.