Assessing Company Health with the Inventory Turnover Ratio

Assessing Company Health with the Inventory Turnover Ratio

Among other measures of company success, a high level of inventory turnover is indicative of a firm that effectively manages its supply chain by minimizing the level of excess stock at any given time. The benefits of a high turnover rate are twofold: first, there is a high opportunity cost associated with keeping revenue invested in inventory as opposed to other, more profitable financial instruments.  A company that invests 25% of its revenue in keeping inventory is making a relative loss to a company that can keep only 15% of its revenue in inventory and invest the 10% differential in stocks or bonds. Second, in rapidly evolving industries —like technology or healthcare— inventory may quickly become obsolete. This rapid depreciation of held inventory, especially in the face of disruptive innovation, can be crippling for companies that fail to adapt to shifting market conditions.[1]

To dig a little deeper into the validity of the inventory turnover ratio as a measure of company health, we have to examine its correlation to other health indicators. We will examine the eight largest firms by revenue in the information technology sector in the US.[2][3] For the reasons outlined above, the IT sector is often touted as the poster child for an extremely high average industry turnover ratio. [4] To make our assessment will consider year-over-year operating income percentage, year-over-year free cash flow growth percentage, and operating margin percentage as our basic indicators of company health. While there are a myriad of potential metrics to choose from, these all do a good job of capturing company growth, while controlling for size.

Before diving into the numbers, it is worth noting that Apple is recognized for having not only one of the best turnover rates in the Information Technology sector, but one of the best turnover rates of any company in any sector.[5] While Apple is obviously an industry leader in many aspects of the Information Technology sector, is its high level of turnover correlated to our selected measures of company health more than for other tech industry giants?

Indicators of Company Health

Company	Turnover Ratio (avg. '04-'13)	Turnover Rank	Operating Income %	OI% Rank	Avg. FCF Growth %	FCF rank	Avg. Operating  Margin %	Rank	Average Rank (b)
Apple	68.74	1	56.3	1	116.8	1	21.69	4	2
Amazon.com	10.61	6	15.64	4	No Data	N/A	3.65	7	5.5
Google	48.2 (a)	2	48.4	2	61.48	2	29.77	2	2
HP	11.85	5	20.55	3	14.89	3	5.64	6	4
IBM	20.71	3	7.05	6	3.87	6	15.73	5	5.67
Intel	4.89	7	6.36	7	8.37	5	25.7	3	5
Microsoft	12.55	4	14.1	5	8.62	4	35.53	1	3.33

a) Google only has turnover ratio information for 2012 and 2013.

b) Average Rank is the mean of all non-Turnover Ratio ranks.

A cursory glance at the above table is enough to establish that there is at least a moderate correlation between turnover ratio and our chosen indicators of company health. Apple and Google share the top spot both of which have a much higher turnover ratio than the other companies on the list. The biggest surprise is probably IBM’s low overall ranking: despite being third overall in turnover ratio, it is ranked last by the average of all other indicators. And, as always, correlation is not causation; many of these indicators may covariate with other variables which were not included in our analysis.

Nonetheless, the evidence is good that there is at least some positive relationship between turnover ratio and overall company health (at least in the tech sector). Ultimately, this study could be expanded by performing a more robust regression analysis with a large number of companies in different sectors.

Questions:

We chose to examine only companies from the Information Technology sector for this post. How does the importance of the turnover ratio changes when looking at other sectors? Are there any sectors for which a high turnover ratio may actually be a bad thing?

How well do the indicators above do at capturing the concept of “company health”? Are there other factors that should be included?

---

[1] For more reading on disruptive innovation, see Clayton Christensen’s seminal The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail. 1997

[2] All financial data are taken from the Morningstar Financials website. <http://financials.morningstar.com/>

[3] We have excluded Dell from this analysis, because its status as a private company makes accurate financial data scarce.

[4] www.csimarket.com lists the top five industries by inventory turnover ratio as:

Industry	Average industry Turnover Ratio (COGS)
Transportation	32.28
Services	30.45
Energy	14.85
Information Technology	10.57
Consumer Discretionary	8.59

[5] http://appleinsider.com/articles/12/05/31/apple_turns_over_entire_inventory_every_five_days