Inventory Turnover Ratio: What is it?
Sometimes a product sells out quickly. Sometimes you just can’t discount deeply enough. However, most products float somewhere in the middle, which means that all businesses need to know what’s moving and how fast. Everything from pricing strategy and supplier connections to promotions and product lifetime is influenced by the inventory turnover calculation.
A company’s turnover ratio also informs a lot about its forecasting, inventory management, and sales and marketing skills. A high ratio indicates either great sales or a lack of inventory to support sales at that rate. A low ratio, on the other hand, suggests poor sales, sluggish market demand, or an inventory surplus.
In any case, knowing where the sales winds are blowing will help you set your company’s sails.
What Is Inventory Turnover Ratio?
The inventory turnover ratio is particularly useful for assessing how effectively a company is converting its inventory into sales. A high ratio implies that the company is efficiently managing its inventory and promptly converting it into revenue. It indicates that the company is avoiding the pitfalls of excess inventory and the associated costs of carrying obsolete or slow-moving items.
How To Calculate Inventory Turnover Ratio?
To calculate the inventory turnover ratio, you need two key values: the cost of goods sold (COGS) and the average inventory value. Here’s the step-by-step process to calculate the inventory turnover ratio:
Determine the Cost of Goods Sold (COGS)
Obtain the COGS value from the company’s financial statements, specifically from the income statement. The COGS represents the direct costs incurred in producing or purchasing the goods sold during a specific period.
1. Calculate the Average Inventory
To calculate the average inventory, you need the beginning inventory and ending inventory values. These values can be found in the company’s balance sheet.
- Beginning Inventory: Obtain the inventory value at the start of the period.
- Ending Inventory: Obtain the inventory value at the end of the period.
Add the beginning and ending inventory values and divide the sum by 2:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
2. Calculate the Inventory Turnover Ratio
Divide the COGS by the average inventory value calculated in step 2:
Inventory Turnover Ratio = COGS / Average Inventory
The resulting ratio will indicate how many times the inventory was sold and replenished during the specific period.
It’s important to note that the COGS and inventory values used in the calculation should be from the same period to ensure accurate results.
By calculating the inventory turnover ratio, businesses can assess the efficiency of their inventory management practices and gain insights into sales effectiveness and inventory control.
What is Ideal Inventory Turnover Ratio?
The ideal inventory turnover ratio can vary depending on the industry, business model, and specific circumstances. However, a higher ratio is generally considered more favorable, as it suggests efficient inventory management and quick inventory turnover.
To understand the concept of the ideal inventory turnover ratio, let’s consider an example –
Suppose you have two companies, Company A and Company B, operating in the retail industry. Both companies have similar product offerings and financial metrics, except for their inventory turnover ratios.
Company A has an inventory turnover ratio of 8, while Company B has a ratio of 4.
In this example, Company A’s higher inventory turnover ratio indicates that it sells and replenishes its inventory eight times within a given period (typically a year). This suggests that Company A effectively manages its inventory, swiftly converting it into sales. It avoids excessive inventory holding costs, reduces the risk of obsolete inventory, and minimizes storage expenses. Company A’s high inventory turnover ratio reflects efficient inventory control and strong sales performance.
On the other hand, Company B has a lower inventory turnover ratio of 4. This indicates that Company B sells and replenishes its inventory only four times within the same period. Compared to Company A, Company B has a slower inventory turnover. This might imply issues such as slower sales, overstocking, or challenges in managing inventory effectively. Company B may face higher carrying costs, a higher risk of obsolete inventory, and potential financial losses if the inventory does not sell as quickly as desired.
Based on this example, we can deduce that a higher inventory turnover ratio is generally considered ideal. However, it is important to note that the ideal ratio can vary across industries. Some industries, like fashion or technology, may have higher ideal ratios due to shorter product lifecycles and faster market trends. Conversely, industries with longer production cycles or higher-value goods, such as automobile manufacturing or luxury goods, may have lower ideal ratios.
To determine the ideal inventory turnover ratio for a specific industry or business, it is recommended to compare the company’s inventory turnover ratio with industry benchmarks and analyze trends within the industry. This can provide a better understanding of how well a company manages its inventory compared to its peers and what improvements might be necessary to optimize inventory turnover.
Why Are Inventory Turns Important?
Inventory turns, also known as inventory turnover, are important for several reasons:
1. Efficient Use of Resources
Inventory represents tied-up capital, and efficient inventory turns indicate that a company is effectively utilizing its resources. Higher inventory turnover means inventory is being sold and replenished quickly, reducing the amount of capital tied up in inventory. This improves cash flow and allows for better allocation of resources to other areas of the business.
2. Cost Reduction
High inventory turns can lead to cost reductions. By minimizing the time inventory spends sitting in storage, companies can reduce associated costs such as storage fees, insurance, and the risk of obsolescence. Additionally, faster inventory turnover reduces the need for excessive safety stock, resulting in lower carrying costs.
3. Sales and Revenue Generation
Inventory turns directly impact sales and revenue generation. Higher turnover ratios suggest that inventory is being converted into sales at a faster rate, leading to increased revenue. This is particularly important for businesses with perishable or time-sensitive products, where rapid turnover ensures freshness and keeps up with changing customer demands.
4. Better Customer Service
Inventory turns play a role in providing excellent customer service. When inventory turnover is high, companies can meet customer demands promptly, reducing stockouts and backorders. This leads to satisfied customers who can find the products they need when they need them, enhancing customer loyalty and fostering positive brand perception.
5. Inventory Management Efficiency
Inventory turns are a measure of inventory management efficiency. A high turnover ratio suggests effective inventory control, accurate demand forecasting, and optimized supply chain management. It indicates that a company can balance inventory levels to meet customer demand without excessive overstocking or understocking.
6. Identifying Issues and Opportunities
Monitoring inventory turns helps identify potential issues and opportunities. A low turnover ratio may indicate slow sales, overstocking, or obsolete inventory, allowing businesses to address these issues promptly. It can also uncover opportunities for process improvements, such as streamlining procurement or optimizing production, to enhance inventory turnover and overall business performance.
7. Financial Performance Assessment
Inventory turns are an important aspect of financial performance assessment. Lenders, investors, and stakeholders often analyze a company’s inventory turnover ratio to assess its operational efficiency, liquidity, and profitability. A high ratio can indicate effective inventory management, which is generally viewed positively by investors and creditors.
Interpretation of Inventory Turnover Ratio
The interpretation of the inventory turnover ratio depends on various factors, including the industry in which the company operates, its business model, and its specific circumstances. However, there are some general guidelines to consider:
1. High Inventory Turnover Ratio
A high inventory turnover ratio is generally preferred because it suggests that a company efficiently manages its inventory and quickly converts it into sales. It indicates strong sales and effective inventory management practices. However, an excessively high ratio may indicate a shortage of inventory, potentially leading to missed sales opportunities.
2. Low Inventory Turnover Ratio
A low inventory turnover ratio can indicate slow sales, overstocking, or holding obsolete inventory. It suggests that the company is not efficiently managing its inventory, which may lead to increased storage costs, potential financial losses, and higher carrying costs. It is important to identify the underlying reasons for the low ratio and take appropriate actions to address the issues.
3. Industry Comparison
The ideal inventory turnover ratio varies across industries. Some industries, such as fashion or electronics, typically have higher turnover ratios due to shorter product lifecycles, while industries like automobile manufacturing may have lower turnover ratios due to longer production cycles. It is crucial to compare a company’s inventory turnover ratio with industry benchmarks to gain meaningful insights.
Inventory turns are important because they reflect the efficient use of resources, contribute to cost reduction, impact sales, and revenue generation, enhance customer service, measure inventory management efficiency, identify issues and opportunities, and play a role in financial performance assessment. Monitoring and optimizing inventory turns can lead to improved profitability, cash flow, and overall business success.