Chartered Financial Analyst (CFA) Level 1 Practice Exam

What is the formula for inventory turnover?

1. Average inventory / cost of goods sold

2. Cost of goods sold / average inventory

3. Revenue / average inventory

4. Average inventory / sales revenue

The correct answer is: Cost of goods sold / average inventory

Inventory turnover is an essential measure of how efficiently a company manages its inventory. The correct formula for inventory turnover is calculated by dividing the cost of goods sold (COGS) by the average inventory during a specific period. This allows businesses to understand how many times inventory is sold and replaced over a certain timeframe. Using cost of goods sold in the numerator provides an accurate reflection of the inventory that has been utilized in generating sales. The average inventory in the denominator accounts for fluctuations in inventory levels over the period, giving a more balanced view of inventory management. This calculation can indicate whether a company is effectively converting its inventory into sales, which is critical for assessing operational efficiency and liquidity. A high inventory turnover rate suggests strong sales, efficient inventory management, or a potential risk of stockouts, while a low rate may indicate overstocking or sluggish sales. Understanding this metric is vital for financial analysis and effective inventory management strategies.