All right. Now let's discuss another ratio, the inventory turnover ratio. So, the amount of cost of goods sold to average inventory levels. Right? We'll discuss this in a little more detail, but the inventory turnover ratio, this is a really common efficiency ratio that you study in this class. Okay? So, we're trying to see how efficiently we use our inventory. Remember, when we have inventory, it costs us money to store whatever boxes. If we sell t-shirts, we've got boxes of t-shirts sitting in a warehouse. Well, that warehouse costs us money, right? So we want to manage that as well as possible.

So, let's look at how we calculate this ratio right here. Inventory turnover ratio, well, it equals cost of goods sold divided by average inventory. Okay? In a lot of ratios, we use this average balance idea. Okay? In the average balance, we're always going to calculate it the same way. We're going to take the beginning balance in that account, plus the ending balance in that account. So we're going to do that first. We're going to add those together and then we're going to divide by 2. Just like you see up here, right? The average inventory, that's the beginning inventory plus the ending inventory divided by 2, right? So that's how we're always going to calculate the average.

Now, sometimes when they give you the inventory turnover ratio, they might just give you one number for inventory. They may not say beginning inventory and ending inventory. Well, if they just give you one number, well, that's going to be your average. That's just going to be what you use for inventory.

In this case, cost of goods sold over average inventory. That's our inventory turnover. COGSavg inventory Okay? So what does this really tell us? It tells us how many times we turned our inventory into COGS. So if you imagine, we're going to have some average level of inventory. Say there's $10,000 worth of t-shirts that sit in our warehouse at any given time. Right? But that $10,000 of t-shirts, well, it doesn't just sit there—that's always there. Right? We're selling t-shirts, we're buying more t-shirts. So, it's kind of a cycle. Right? If you think about it, we're going to have some number for cost of goods sold and it's related to inventory because every time we make a sale, right, it comes out of inventory. The cost of goods sold come out of inventory.

We're going to have this average balance that we keep in our inventory, but we're going to be selling it. So, we would expect that we would turn that inventory into COGS. Hopefully, a few times, right? It'd be more efficient the lower amount of inventory we can keep and just sell COGS and COGS and just be making lots of sales, right? So the idea here is how efficiently are we using those inventory levels?

Think about it. Wouldn't it be most efficient if we didn't have to hold any t-shirts at all? If our inventory was 0, but we were able to just make tons and tons of sales. So, every time we needed a t-shirt, instead of going to our warehouse and having all these costs to maintain a warehouse, well that t-shirt just went straight to the customer from the factory that prints them or whatever it is. Well, that would be very efficient because we don't have any warehouse cost at that point. But it's still efficient to keep a very manageable amount of inventory. Maybe we can keep just the right amount of inventory, just a small amount of inventory that we can keep turning without ever running out, right? If we keep too little inventory, maybe we run into the problem that we get orders from customers and we can't fill them because we don't have enough inventory. So, we want to be able to manage that inventory properly so that we were able to keep up with our sales, but also maintain our warehouse cost at a reasonable level.

So that's what the inventory turnover is trying to tell us here. Okay? So how do we compare our inventory turnover? Like a lot of ratios, we use benchmarking. We want to be able to compare our inventory turnover to other companies in our industry. How well are we managing our inventory compared to our competitors, right? If it takes us huge warehouses to manage our t-shirt business and we've got to have thousands of boxes of t-shirts just sitting there costing us money and there's another company that, hey, they just print it and send it to the customer right away. Well, they're going to have a lot more efficient management of their inventory, right? So we want to benchmark against our competitors and see if we're turning our inventory faster, right? So what we want is high inventory turnovers. Higher inventory turnover ratios means we're being more efficient with our inventory, right? So that's basically how we analyze inventory turnover.

Why don't we go ahead and move into this example and see how we calculate an inventory turnover ratio? Let's do it right now. So, this first question right here, XYZ company had net sales of 500,000 and COGS of 320,000. If the beginning balance of inventory was 60,000 and the ending balance of inventory was 100,000, what is the inventory turnover ratio?

Notice they talk to us about net sales in this question and this is a classic way that they try and trip you up with inventory turnover as they talk about net sales. But remember when we're doing inventory turnover, when we sell inventory, well, our sales revenue is related to the cash we receive from customers, right? The selling price of the good. But inventory and COGS, that relates to what we paid for the goods. So inventory is related to COGS where sales revenue is more related to the cash we receive from customer, the selling price of the good.

So they're generally going to try and trick you like this and throw in a net sales number. But remember, inventory turnover, we want to use COGS here. Okay? So that's our good number. COGS,320,000avg inventory, that's going to be our numerator. What about our denominator, right? We have to calculate that average inventory balance. So, in this case, they gave us two numbers, right? They gave us a beginning and ending balance, so we have to calculate an average.

Let's do our average inventory first, right. So, it gave us a beginning balance of inventory was 60,000. Our ending balance of inventory was 100,000. Well, the average inventory 60,000+100,0002 is going to give us 80,000 as our average inventory balance. So, we're not done yet. Now, we've got to actually calculate our inventory turnover.

So inventory turnover, remember that's going to be COGSavg inventory. We've got those numbers ready. We've got our COGS of 320,000. We've got our average inventory of 80,000. So, we've got an inventory turnover of 4 in this case, right? Four times. So that means during the year, we were able to turn our average inventory balance, this 80,000 that's usually sitting in our warehouse, we turned it into $320,000 worth of sales. We were able to turn that average inventory into 4 times the amount of sales in COGS. Right?

Hopefully, that makes sense to you right there and that is our answer here. So, 4.0, that is our inventory turnover. Turnover ratios are usually a little more complicated to understand the logic, but if you think about it like that, right, how many times we turn that average inventory, what we have sitting in our warehouse, how many times we're able to flip that and turn it into COGS, right? Make sales and turn that inventory, get it out of the warehouse. So, basically everything that was sitting in the warehouse was able to move out of the warehouse 4 times during the year. Cool? Let's go ahead and move on to this practice problem where you guys get to try and solve inventory turnover.