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. Inventory that lies piled up in a warehouse costs money that you have to bear the brunt of and pay for. So, the faster the inventory is sold out, the better.
How to calculate inventory turnover ratio?
A company’s turnover ratio should be compared with the following:
- The industry average
- Its planned ratio
- Its previous ratio
You need to measure this ratio over a set period of time. This way, you can compare it with past and future timelines. Most retailers usually measure it over a span of a year.
There are two formulae used for calculating inventory turnover ratio:
Inventory turnover ratio = (Cost of Goods Sold)/(Average Inventory)
Cost of Goods Sold (COGS) is the total cost spent on manufacturing products including the labor cost that is directly related to the manufacturing of the products. COGS doesn’t include shipping and distribution that are not directly related to the manufacturing of the product.
Inventory turnover ratio = (Sales Made)/ (Average Inventory)
This formula does not give you accurate results of the inventory turn. This formula divides the total sales made, by 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.
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.
Let’s look at an example for more clarity:
John is a retailer who sells home appliances. He calculated COGS at the end of the year to be $10,00,000. The value of his total inventory at the beginning of the year was $30,00,000 and that at the end of the year was $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 current inventory.
This is not a very good value and shows that John has either overstocked his inventory, or that 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 the product being sold, the value of inventory turnover will differ.
However, it should not go lower than 3 in any case.
Industries holding high volumes of inventory and having low margins are generally the ones that have high inventory turnover value. For example, industries like retail, grocery and clothing stores are the ones that have a higher value of inventory turnover.
Typically, a grocery store has an inventory turnover of the value 19. These industries need to offset lower per-unit profits with higher unit sales volume. They need a higher inventory turnover ratio to remain cash-flow positive.
What does a decreasing Inventory Turnover Ratio indicate?
A decreasing inventory turnover ratio indicates one or more of the following reasons:
- Your inventory is held in the warehouse for too long
- You’ve purchased too much product
- Your marketing efforts need to be reevaluated
What are the limitations of Inventory Turnover Ratio?
Inventory turnover ratio can show a high value even when the average inventory value is lesser. This can be misleading because this time the higher value of inventory turnover ratio does not mean better sales or inventory management.
Many a times, inventory turnover ratio cannot tell the seller the exact situation of the business. For example, under a particular situation, sellers could suddenly run out of stock. In this condition, the inventory turnover could be higher. However, this is not an indicator of good sales.
How to improve inventory turnover ratio?
- Use a purchase order management software to accurately track your purchases and forecast what will move better if purchased.
- Implement an inventory management software to get real-time updates of inventory. This will help you avoid overselling, underselling and stock-outs.
- Use proper warehouse management techniques. Very organized warehousing is essential to know what exactly you have in stock.
- Use great marketing and sales techniques.
- Focus on the top-selling products- stock more of the products that bring you more sales than others.
A high inventory turnover ratio is always important. At the same time, it is important to have a frequent analysis of your inventory in order have better clarity of the situation pertaining to your stock.