Inventory turnover ratio is one of the important metrics that tells a business of its performance. It is very essential to have at least a yearly analysis of your inventory turnover ratio and direct your operations accordingly.
What is inventory turnover ratio?
Inventory turnover ratio is the rate at which inventory is ‘turned’ or sold by a company. It shows the company’s ability to convert its inventory into cash.
One of the most important factors determining the success of a business is its efficiency in inventory management. The entire inventory that lies piled up in a warehouse is worth the storage and many other costs that the seller has to pay. So, the faster the inventory is sold out, the better.
How to calculate inventory turnover ratio?
A company’s inventory turnover ratio should be compared with the following: 1) The industry average 2) Its planned ratio, and 3) its previous ratio
One has to specify a certain time period over which he/she needs to measure the inventory turnover. It is typically measured over a period of one year.
There are 2 formulas used for calculating inventory turnover ratio:
1. Inventory turnover ratio = (Cost of Goods Sold)/(Average Inventory)
The Cost of Goods Sold (COGS) is the total cost spent on manufacturing products including the labor cost that are directly related to manufacturing of the products. COGS doesn’t include shipping and distribution that are not directly related to the manufacturing of the product.
2. Inventory turnover ratio = (Sales Made)/(Average Inventory)
This formula does not give you accurate results of the inventory turned. This formula divides the total amount of sales made by the company at the end of the time period considered with the average inventory value.
This formula is used to get a quick estimate of the inventory turned, but it gives you a value that is higher than the actual inventory turnover ratio.
It is better to calculate weekly or monthly data of inventory in order to calculate the average value. This gives a much more accurate account of your average inventory rather than taking the inventory value at the end of the year. This would be a more vague value.
Let’s look at an example for more clarity:
John is a retailer who sells home appliances. The COGS at the end of the year was calculated by him to be $10,00,000. The value of his total inventory at the beginning of the year was $30,00,000 and that the end of the year $20,00,000.
This means that the average inventory value for that particular year = (30,00,000 +20,00,000) / 2 = 25,00,000
Thus, the inventory turnover ratio = 10,00,000 / 25,00,000= 0.4
This means that John’s inventory turned approximately 2/5 times in a year. This means that it will take John almost 2 and a half years (5/2 years) to sell his entire inventory.
This is not a very good value and shows that John has either overstocked his inventory or his sales and marketing efforts are not that great.
The inventory turnover ratio is generally specific to each industry. Depending on the size of the business and the category of product being sold, the value of inventory turnover will differ. However, it should not go lower than 3 in any case.
You must always keep a close watch on your inventory turnover ratio. There are multiple reasons why your inventory turnover could be decreasing.
Find out more about how you can improve your inventory turnover ratio- Download our free guide here!