CFA Level I Exam · Analysis of Inventories

Inventory Ratios and Financial Statement Analysis

Updated 7 October 2026 · Fact-checked

Inventory turnover is cost of goods sold divided by average inventory. Days of inventory on hand is 365 divided by turnover. Gross margin is gross profit divided by revenue. To solve questions, compute the ratios, compare them with peers and history, then check whether the inventory method, write-downs or disclosures explain the change.

Understand Inventory Ratios and Financial Statement Analysis

Inventory is a bridge between the balance sheet and the income statement. When goods are sold, their cost moves from inventory (an asset) to cost of goods sold (COGS, an expense). So ratios that link COGS and inventory tell you how fast a company converts stock into sales.

Inventory turnover shows how many times a year the company sells through its average inventory. Days of inventory on hand (DOH) is the same idea in days: how long the average item sits before it is sold. A high turnover means a low DOH, and the two always move in opposite directions.

High turnover is not automatically good. It can mean tight inventory control and strong demand. It can also mean the company holds too little stock and loses sales, or it is cutting prices to clear goods. Low turnover can mean weak demand, obsolete stock or overbuying. Always read turnover together with gross margin and sales growth. High turnover with a falling gross margin suggests discounting. Low turnover with a rising gross margin may point to a slow-moving but premium product, or to a problem hidden in the numbers.

Inventory method choices change the ratios. Under rising prices, LIFO (allowed under US GAAP, not under IFRS) puts recent, higher costs into COGS. That gives higher COGS, lower gross margin, and an older, lower inventory balance than FIFO. LIFO therefore usually shows a higher turnover and lower DOH than FIFO. To compare a LIFO company with a FIFO company, convert the LIFO figures using the LIFO reserve.

Disclosures help you test quality. Look for the cost formula used, the carrying amount by category, the amount of write-downs and reversals, inventory pledged as security, and the cost recognised as an expense. Red flags include inventory growing much faster than sales, rising DOH with no explanation, large write-downs, a sudden change in method, and LIFO liquidation (selling more units than were bought, which pulls old low-cost layers into COGS and lifts profit).

Key formulas to remember

Inventory turnover: Inventory turnover = COGS ÷ Average inventory; Average inventory = (beginning + ending) ÷ 2, unless the question says to use another figure. Use COGS, not sales.
Days of inventory on hand (DOH): DOH = Number of days in period ÷ Inventory turnover = Average inventory ÷ COGS × Number of days; Use 365 unless the question gives another day count.
Gross profit margin: Gross margin = (Revenue − COGS) ÷ Revenue; A change in inventory method flows straight into this ratio through COGS.
LIFO to FIFO inventory: FIFO inventory = LIFO inventory + LIFO reserve; Do this for both beginning and ending balances if averaging.
LIFO to FIFO COGS: FIFO COGS = LIFO COGS − (Ending LIFO reserve − Beginning LIFO reserve); When the reserve rises, FIFO COGS is lower than LIFO COGS. When prices fall or the reserve shrinks, the adjustment reverses.
Cash conversion cycle link: Cash conversion cycle = DSO + DOH − Days payable outstanding; DOH is one of three components, so rising DOH lengthens the cycle.
Write-down rules: IFRS: inventory is carried at the lower of cost and net realisable value (NRV). Reversals are allowed, limited to the amount of the original write-down, so the carrying amount never exceeds original cost. US GAAP: reversals are not allowed.; The lower-of-cost-or-market rule is a US GAAP rule only. Under US GAAP, FIFO and average cost use lower of cost and NRV, while LIFO and the retail method use lower of cost or market. IFRS has no LIFO and applies lower of cost and NRV to every permitted cost formula.

How to solve Inventory Ratios and Financial Statement Analysis questions

Use this order for any inventory-ratio question. It stops you from picking the wrong inputs and helps you eliminate two of the three options.

1Read what is asked: turnover, DOH, gross margin, an interpretation, or a comparison between companies.
2Identify the inventory method (FIFO, LIFO, weighted average) and the accounting framework (IFRS or US GAAP).
3Pick the right inputs: COGS for the numerator, average inventory for the denominator, revenue for margin. Check whether the question gives an average or two balances.
4If companies use different methods, convert LIFO to FIFO with the LIFO reserve before you compare.
5Calculate turnover, then DOH = days ÷ turnover. Check that your answer moves the right way: higher turnover must mean lower DOH.
6Interpret in context: compare with prior years and peers, and read turnover together with gross margin and sales growth.
7Scan the disclosures or scenario for red flags: write-downs, reversals, method changes, pledged inventory, LIFO liquidation.
8Match your result to the three options. Numerical options go from smallest to largest, so check that your number fits the order and eliminate options built from common input errors.

Quickest way: Three-input shortcut

When to use it: Use it for straight calculation questions where the question gives COGS and inventory balances.

Write down COGS and the two inventory balances. Average them first.
On a BA II Plus, key COGS ÷ average inventory = to get turnover. Then compute DOH by keying 365 ÷ and retyping the turnover shown (for example 365 ÷ 4.2 =). Do not rely on a recall key.
Quick check: DOH ≈ average inventory ÷ COGS × 365. If this differs from your first result, you made an input error.
Compute the options that use ending-only or beginning-only inventory in your head. These are usually the two wrong options.
For LIFO questions, add the reserve to inventory and subtract the change in reserve from COGS. Do not do anything else.

Common mistakes in Inventory Ratios and Financial Statement Analysis

Using sales instead of COGS in turnover.
Many other turnover ratios, such as receivables turnover, use revenue, so students apply the same habit.
Fix: Inventory is carried at cost, so match it with COGS. Use revenue only for gross margin.
Using ending inventory instead of average inventory.
It is faster, and the balance sheet shows the ending number first.
Fix: Average the beginning and ending balances unless the question tells you otherwise. The wrong-input answers are usually among the options.
Treating high turnover as always good.
Students link speed with efficiency and stop there.
Fix: Check gross margin and sales trend. High turnover with falling margin may mean discounting. Very high turnover can mean stock-outs and lost sales.
Getting the LIFO-to-FIFO adjustment backwards.
Students remember the reserve but not which line it adds to or subtracts from.
Fix: Reserve is added to inventory. The change in reserve is subtracted from COGS when the reserve rises, since FIFO COGS is lower in rising prices.
Comparing LIFO and FIFO companies without adjusting.
The ratios look comparable, so the method difference is overlooked.
Fix: Convert to the same basis first. Remember that IFRS does not allow LIFO, so a LIFO company is reporting under US GAAP.
Missing LIFO liquidation as a driver of profit.
Students see higher gross margin and assume better operations.
Fix: If inventory units fall and the LIFO reserve drops, old low-cost layers may have flowed into COGS. Treat that margin gain as non-recurring.

Worked examples

Example 1

A company reports COGS of €840 million for the year. Inventory was €180 million at the start and €220 million at the end. Using 365 days and average inventory, what is days of inventory on hand? A) 78.2 days B) 86.9 days C) 95.6 days

Show the solution

Average inventory = (180 + 220) ÷ 2 = €200 million.
Inventory turnover = 840 ÷ 200 = 4.2 times.
DOH = 365 ÷ 4.2 = 86.9 days.
Check the other options: option A uses beginning inventory only (365 ÷ (840 ÷ 180) = 78.2). Option C uses ending inventory only (365 ÷ (840 ÷ 220) = 95.6). Both use the wrong inventory figure.

Answer: B) 86.9 days

Example 2

A US GAAP company using LIFO reports revenue of $900 million and COGS of $620 million. Its LIFO reserve rose from $40 million to $55 million during the year. What is its gross margin if it had used FIFO? A) 29.4% B) 31.1% C) 32.8%

Show the solution

Change in LIFO reserve = 55 − 40 = $15 million.
FIFO COGS = LIFO COGS − change in reserve = 620 − 15 = $605 million.
FIFO gross profit = 900 − 605 = $295 million.
FIFO gross margin = 295 ÷ 900 = 32.8%.
Check the others: 31.1% is the reported LIFO margin ((900 − 620) ÷ 900). 29.4% comes from wrongly adding the change to COGS ((900 − 635) ÷ 900). With rising prices, FIFO margin must be above LIFO margin, which confirms the answer.

Answer: C) 32.8%

Exam tips

Eliminate by input. Wrong options are often built from sales instead of COGS, or ending instead of average inventory. Compute those quickly to see which options they match.
Remember the direction: rising prices mean LIFO has higher COGS, lower gross margin, lower inventory and lower reported profit than FIFO. Use this to rule out options that go the wrong way.
For interpretation items, avoid absolute words. Turnover or DOH only signals something when compared with peers, history and gross margin.
Know the IFRS/US GAAP differences: LIFO is not allowed under IFRS, and write-down reversals are allowed under IFRS but not under US GAAP.
Use the question's day count. If it says 360, use 360. Otherwise use 365.

Practice questions from Analysis of Inventories

Inventory Ratios and Financial Statement Analysis in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Inventory Ratios and Financial Statement Analysis: frequently asked questions

What is the formula for inventory turnover and days of inventory on hand?

Inventory turnover is COGS divided by average inventory. Days of inventory on hand is the number of days in the period divided by turnover, usually 365 ÷ turnover. You can also compute it as average inventory ÷ COGS × 365.

What does high inventory turnover indicate?

It usually means the company sells stock quickly and holds little idle inventory. It can also mean stock-outs or heavy price cuts. Check gross margin and sales growth before deciding it is a strength.

How does the choice of LIFO or FIFO affect inventory ratios?

In rising prices, LIFO reports higher COGS and lower ending inventory than FIFO. That gives a lower gross margin, a higher turnover and a lower DOH. Use the LIFO reserve to convert to FIFO before comparing companies.

What inventory red flags does the CFA Level I exam test?

Common ones are inventory growing faster than sales, rising DOH, large write-downs, changes in cost formula, and LIFO liquidation boosting profit. Disclosures on write-downs, reversals and pledged inventory help you spot these.