You Gotta Know the Lingo, Vol. 3: Inventory Turnover

Fans of The Motley Fool can't help but be aware that it's practically impossible for Wall Street pundits and writers to communicate without some obscure patois slipping into the mix. It's not their fault, of course. The purpose of specialized argot in any arena is to provide folks with shorthand so they don't have to keep repeating long phrases to describe things like "employer-sponsored, tax-advantaged investment accounts whose funds are intended only to be withdrawn in retirement." So much easier just to say "401(k)."

But if you want to play the game, you have to comprehend the conversation, so in this week's Rule Breaker Investing podcast, Motley Fool co-founder David Gardner is bringing in a trio of special Foolish guests to explain six terms that investors might not know as well as they think they do or as well as they'd like to. In this segment, Industry Focus host Sarah Priestley gives us the lowdown on what exactly inventory turnover means and why it matters.

A full transcript follows the video.

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This video was recorded on Feb. 21, 2018.

David Gardner: Sarah Priestley, you've got term No. 6 for us. What is it?

Sarah Priestley: "Inventory turnover."

Gardner: Inventory turnover. The way that you said it with your British accent, it sounded almost like "infantry" turnover, which...

Priestley: Sorry!

Gardner: ... would be a very bad thing, don't you think?

Priestley: Yes, probably I don't enunciate. Inventory.

Gardner: No, you do great, but infantry turnover would be troubling.

Priestley: It would be very troubling.

Gardner: That's something that we're not looking to promote, or do, or make happen on this show. More seriously, Sarah, inventory turnover. I got it. Define it.

Priestley: It's an efficiency ratio. It measures the rate a company purchases and then resells products to customers. In its most simple form, that's what it is. And you can work it out one of two ways. One is market value of sales divided by ending inventory. Or cost of goods sold divided by average inventory, and this is what I would say is the preferred metric because average inventory accounts for seasonal fluctuations. So, if you're Canada Goose, for example, which is heavily reliant on the winter season -- it sells big parka coats -- then you're going to want to rule out, you're going to want to flatten some of those peaks and drops.

Gardner: So, you've already given us two ways to think about or calculate it. I want to take a step back. For those of us who didn't have an accounting course, or don't work in this field full-time, this is a more advanced term or concept. Sarah, when we talk about inventory turnover, why would we bother measuring that? What is the usefulness of that if you're looking at financial statements or thinking about a business?

Priestley: I like to use it, especially within the industry that I cover. On the Industry Focus show we look at a lot of industrial companies, and it's hugely important to see how well, especially in manufacturing, your production planning is. So, a low inventory turnover implies weak sales.

This could be due to a poor performing product line, bad marketing, production bottlenecks; but, the issue with this is it leads to excess inventory, so for any business that handles any physical item, excess inventory is a bad thing, because there's a holding cost to old inventory. In manufacturing, it's work in progress, and that capital could be better allocated. Elsewhere in retail, especially fashion retail, once you've gone past the season those items become obsolete, and you have to reduce the margin.

So, high turnover, conversely, generally implies good sales and efficient production planning. It also means that the company is at less risk of being stuck with a load of inventory and that they're replenishing their cash quickly. These tend to be the companies that are more responsive to changes in customer demand. They tend to be more nimble.

Gardner: I know we have a lot of entrepreneurs listening to this podcast, and a lot of you, obviously, are familiar and thinking about inventory turnover. A big story over the last 20 years has been that you have to have more inventory if you have a bricks and mortar store. If you have a physical presence, you're required to have more inventory. And if you do -- if you're Wal-Mart or somebody else -- you want to get as good as possible at identifying what should be on the shelves and turn it over as fast as possible.

Again, I know a lot of entrepreneurs are going to be familiar with this concept. But for those who aren't, Sarah, I know that you came to us from Rolls-Royce, right?

Priestley: Yes, absolutely. We used the metric a lot. It was something that I was driven to on the shop floor to make sure that we had, they call it turns. You want as many turns per possible per quarter per year.

Gardner: And what would it be for an automobile company?

Priestley: For an automobile company -- I was actually looking at these figures before I came in for my example -- a great example is Ford. I think they had 10.9 turns per quarter. That equates to something around six days. It takes them six days to take one item from nothing, create it, and ship it to the customer.

Gardner: Which sounds remarkable to me. It makes me think my Ford shares should be doing better than they have over the last five years.

Priestley: Yes, it's all that debt. But the important thing, as you mentioned, is Wal-Mart would want extremely fast turnover, and then it's slightly different for automobile manufacturing companies. You have to apply it to the context of the industry. It has to be apples to apples, so don't compare automotive to grocer if you're trying to make an investment decision.

Gardner: It is all relative. Looking even more broadly, like over the last century, is it a fair generalization to say that inventory turns have gotten faster in business because of all the logistics we have today and the digital?

Priestley: Absolutely. Definitely. And in manufacturing, which I keep on harking on about, but in manufacturing, particularly, the rise of just-in-time, lean six sigma has really revolutionized how quickly we can extrapolate things out to the customer. And as you quite rightly said, digital. The thing that it has enabled us to do is just get so quick with the supply chain.

And one thing to really focus on with this -- if you're looking at inventory turnover and it seems like they have an exceptionally good inventory turnover, so they turn over a lot of stuff very quickly -- is that could be a bad sign because it could mean that they have poor purchasing planning, so if they're leaving money on the table by essentially every time that they supply the end retailer it sells out straight away, then maybe we need to address that, too.

Gardner: I see that. If the shelves are bare because people keep buying the stuff and they're not supplying enough, it might look great from an inventory turnover standpoint, but not a very good business.

Priestley: Absolutely.

Gardner: Sarah, are you prepared to use this in the final sentence for this week's podcast?

Priestley: Yes.

Gardner: Is it going to be like one of Abi's sentences with semicolons, or is it a consummately over prepared, beautifully written English sentence?

Priestley: I don't know that I would say, but I'll do my best. Judging on inventory turnover, Ford stock looks slightly more efficient than Tesla stock, as Ford has six days. Tesla has 20 days.

David Gardner owns shares of Ford and Tesla. Sarah Priestley has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Ford and Tesla. The Motley Fool has a disclosure policy.