Inventory Turnover Ratio: Simple Formula & How to Calculate
Inventory Turnover Ratio: What It Means For Your Business
In any industry, inventory management is a key business operation. For one, knowing your inventory turnover directly impacts sales, business costs, and financial projections. It helps you price your products correctly, make production more efficient and streamline warehouse operations.
On the other hand, a business that stays on top of inventory management is more successful in the long run because of the trust established with its customers and the ability to make smarter decisions based on clear insights. In short, it’s critical to the health of your business.
Do you know how to calculate inventory turnover ratio for your business? If you don’t, there’s a lot of potential information you could be missing on inventory turnover. We’ve created a guide to help you identify what you need to know about the general issue and how to carry out this crucial calculation.
What is Inventory Turnover Ratio?
To understand this term we’ll first go into the definition of “inventory” and “inventory turnover.”
Inventory consists of all the goods a company offers for sale. This could be finished goods that were bought in wholesale and resold at a profit such as clothing or food items, or raw goods.
Manufacturing companies’ inventory consists mainly of raw goods and other finished items that work as product components. For example, a bag maker would have leather, pleather, or other materials as raw goods, together with finished items like emblems or packaging. These are all considered inventory.
The amount of this inventory or stock sold in a specific period of time makes up the inventory turnover. Most companies express this as a ratio. Thus, inventory turnover ratio is a measure of how many times a company has sold and replaced its inventory during a certain period of time.
It’s used as a tool to evaluate the liquidity of a company’s inventory and is an important accounting formula for many companies because it measures the efficiency of the business in managing and selling its inventory.
Low inventory turnover could mean that its products are not selling, or they are either overstocking or restocking their products slowly. On the other hand, a company with a high inventory ratio shows demand for products is high and there is a profitable balance between sales and inventory turns. This is one of the reasons why tracking this metric is so important for a business.
How To Calculate Inventory Turnover
Before you start, you’ll need to identify the data you need to carry out this calculation. The variables of an inventory turnover formula include:
- Time period: This ratio is measured over a specific period
- Sales: The dollar figure for all your sales in one year. In order to calculate the ratio, use the figure for net sales or cost of goods sold from the company’s income statement and inventory from its balance sheet. This includes the value of the stock that you’ve sold within that period but hasn’t received payment for yet.
- Cost of goods sold (COGS): This is how much you sold your product for, the price, but is often termed as “cost” of goods to include the cost of raw materials, direct labor, or direct factory overheads used to produce the product for sale.
- Average Inventory Formula: Arrived at by adding the dollar amount of the starting inventory (beginning of the year in this case) with the finishing inventory (year-end) and dividing by two.
With those figures in hand, there are two different methods for calculating inventory turnover ratio. The first inventory turnover calculator is where sales are divided by average inventory
-Net Sales / Average Inventory # of times turned over
The second inventory turns formula divides the cost of goods sold (COGS) by your average inventory:
-Cost of Goods Sold / Average Inventory = # of times turned over
Analysts believe that using the second formula where the COGS is divided by average inventory instead of the first formula is more accurate. This is because sales include a markup over costs, and this inflates the inventory turnover ratio.
What is the best inventory turnover ratio? It depends on the industry. For example, a grocery store would have a higher ratio than an automobile dealer. This doesn’t mean that the grocery store is performing better in terms of profits, they just happen to stock faster-moving goods.
The Benefits of Calculating Inventory Turnover
Business owners may neglect to calculate their business turnover ratio when they think they have a hand on things, however, there’s a reason why analysts insist on this calculation. Your inventory turnover ratio is important for the following reasons:
1. It tells you how quickly your company is selling inventory
As mentioned before, a high inventory ratio generally indicates that a company is efficiently managing its inventory and selling their products. Faster sales mean more liquidity because money is not tied up in inventory, and most likely a profit is being achieved.
However, too high a ratio means products are selling out too fast and the company might end up missing out on sales and disappointing customers. The silver lining is that high demand presents an opportunity for the company to increase the price of a product.
On the other hand, a low inventory turnover ratio is an indicator of a slow-moving product. A company may even be holding obsolete inventory. This ties up the company’s capital and eats into profits.
There are some instances where a company may be holding on to its stock such as in preparation for the holiday season or a special event. Or maybe they’ve received word of a suppliers’ strike in the near future—Industry forecasts are important to business efficiency.
2. It provides a comparison to others in your industry
Having an accurate comparison to industry averages through numbers is important for measuring your company’s performance. If your turnover ratio is lower than other similar businesses in your area, it could highlight inefficiencies in your production or some opportunities in the market that you are not taking advantage of.
3. Gives you insight into the workings of your company
In the same way that comparing with others can highlight several things, calculating your inventory turnover gives you clear insight into your operations. Your ratio will tell you how well you are managing your stock, sales performance, cost inefficiencies, and other valuable insights.
Not only does this provide a picture of whether products are in demand or obsolete, it also gives a clear picture of management and company culture.
How To Improve Your Inventory Turnover Ratio
Here are some strategies to help you improve your inventory turnover.
1. Improve your Marketing
The heart of your business success lies in its marketing. An effective marketing strategy will involve many activities, including advertising, promotions, and public relations. Reaching new customers and attaining a competitive edge will increase sales and thus improve inventory turnover. You never know, maybe your product is slow on the shelves because the market doesn’t know how amazing it is!
2. Stock Inventory That Sells
This might seem obvious, but a lot of business owners purchase inventory on misconceptions and lack of market understanding. This leads to stocking products that do not do well in the market. If you have an idea for a new product, test out reception by customers first by stocking a small amount. This can help you avoid headaches where you thought you had a great product but uptake was disappointing.
3. Ensure Efficient Restocking
Where you have popular products that are flying off the shelves, adjust your inventory to ensure they stay in stock. The best way to do this is by increasing the rate at which you stock the product, rather than purchasing large amounts at a time. Overstocking not only ties up your business capital, it could also lead to having dead stock should the product go out of season or popularity dies down suddenly.
4. Push Old Stock
Avoid old stock becoming dead stock by offering sales, special discounts, and promotions, applying specific marketing strategies, and more. Any business should avoid having old stock as all costs as it ties up capital thus burdening the company.
5. Make Use of Business Forecasting
Different times of the year come with different demands: Holidays, back-to-school periods, and of course, weather seasons. All this will have a big impact on your inventory and any smart business owner should have inventory strategies to anticipate not only this but emergencies such as supply interruptions.
6. Use Smart Pricing Strategies
Rather than use a single pricing strategy for all your stock, consider custom pricing for a variety of products. Factor these on seasons, shipping requirements, cost of production, shelf life, and such.
7. Review Purchase Rates Regularly
Keep your ear to the ground on what’s happening in your industry. Has there been a surplus of raw products that should reduce prices, have your suppliers applied a more efficient procedure? Knowing all this information can help you negotiate lower prices for your stock, which translates to lower prices for your customers thus higher demand.
8. Invest in Automation Software
You can’t manage every aspect of your business, and even if you can, a computer can probably do it ten times more efficiently. Investing in things that help your business automate tasks like a retail POS system, inventory management platform, or marketing automation will not only increase efficiency, it will free up much-needed time to focus on other aspects of the business.
Inventory management can be tricky, but it is important to learn because it keeps your business working well. Revel Systems’ enterprise POS and business platform can help single or multi-location businesses streamline operations such as inventory management. Contact us to learn more about our services and get a free demo.