What is Inventory Turnover Ratio and How Is it Calculated?

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Inventory. It’s always an issue with a business. Whether a company is bringing in and storing finished products for resale or holding raw materials, products in process, and finished products, inventory is both an asset and a liability.

An inventory is an asset if it is moving. It is a liability when it is not moving fast enough. And business managers use all sorts of information and data to try to figure out how much inventory to order in a given period of time, often based on past experiences.

Newer data algorithms can predict the demand. Such predictive analytics models are certainly adding science to “gut feelings”. But there are other factors involved in inventory planning too

One of these factors is known as inventory turnover ratio.

Just What is Inventory Turnover Ratio?

It’s pretty clear what inventory is. The term turnover refers to how long it takes for a current inventory to be sold or used up and to be in need of replacement. This is an important factor in business cash flow management. If too much inventory merely sits in your warehouse, it becomes a liability and indicates that demand is low for some reason. So an entrepreneur will rush to discover what that reason is and fix it.

Turnover ratio is a mathematical figure that shows the relationship between inventory and its depletion through sales. In general, the higher the ratio, the better a business is performing, because its inventory gets sold out quickly. It could also mean that a company is not keeping enough inventory and is running out too quickly, thus losing potential sales. In fact, 37% of ecommerce companies are guilty of late shipping because they sell products that are not actually in stock.

A low turnover ratio, on the other hand, means that inventory is on a path to become deadstock – something you cannot get rid of.  This can be a problem of poor marketing, decrease in demand for some products, or could indicate that a company is buying too much inventory.

How to Figure Your Inventory Turnover Ratio

Determining the inventory turnover ratio is important because it can tell you about the strengths and weaknesses of your current inventory practices. And correcting those weaknesses will always positively impact your bottom line.

The inventory turnover ratio formula is relatively simple:

Cost of Goods Sold ÷ Average Inventory = Turnover Ratio

The cost of goods sold (COGS) is a figure that takes into account all production costs and can include cost of raw materials, labor, any factory and storage overhead, and any fixed costs for the production of goods.

For example, a retailer does not typically manufacture products. He buys them at wholesale prices and sells them at a profit. The cost of goods sold in this case would include:

  • wholesale price
  • shipping costs
  • the costs of warehousing the inventory  (utilities, warehouse employees)
  • sales floor costs, clerks,
  • packaging
  • shipping

If you are dropshipping products, your COGS will be much lower as part of these costs go to your partner. In general, every operation is somewhat unique, of course, and the cost of goods sold (COGS) will include some unique factors. For example,perishable goods vs. non-perishables will impact temperature controls.

Average Inventory. This figure is used rather than actual inventory, because the inventory turnover ratio is figured for a period of time – usually quarterly or annually. Many companies have varying inventories dependent upon time of year. A toy store, for example, ramps up its inventory prior to the holidays (during Q4), but cuts way back once those holidays are over (Q1). For this reason, many companies do quarterly inventory turnover ratios but then do an annual one as well.

A Simple Example of Inventory Turnover Ratio Calculation

Suppose that a small retailer has calculated that his COGS in a given year was $200,000 and his average inventory was $20,000. The division results in a ratio of 10. This means that during that year, he sold and replaced his inventory 10 times. He is doing well. Now, he needs to determine if, during the year, he ran out of inventory and had to tell customers that items were on “back order.” Perhaps, this retailer should consider keeping a bit larger inventory going forward.

On a larger scale, Walmart, in January, 2018, reported an annual COGS of $373.40 billion, and its year-end inventory was $43.78 Billion. Using the formula, the inventory turnover ratio was 8.53 – a good number.

What is a Good Inventory Turnover Ratio?

The easy answer, of course, is as high as possible. This means that inventory is moving out at a great pace and bringing in profit. But there are other factors involved as well such as stock shelf life and product holding/carrying costs.

Suppose, for example, that in order to move some of that inventory, you had to offer it at discounted prices. Sales pick up, your inventory liability goes down, and your turnover ratio will still look good. But your profits will decrease.

Inventory turnover ratio is still an important piece of your business financial “pie.” But, in truth a “good” turnover ratio will be one that maintains good operating income and profit, that reduces the length that inventory is held, and that will optimize your holding costs.

What a Business Can Learn from its Inventory Turnover Ratio?

First and foremost, this ratio is one good measurement tool to describe how well a business is moving its inventory through sales. It also speaks to how well you are managing the costs related to inventory and if your business is producing or buying too much or too little stock.

The ratio can also point out how well the marketing and sales teams are performing – a high ratio means these folks are doing their jobs well enough. A low ratio may indicate that those teams are under-performing.

A very high ratio can also mean that your company is not producing or purchasing enough inventory – demand may be greater than supply.

General Tips to Improve Your Turnover Ratio

While the inventory ratio is not a “be-all, end-all” indicator of financial health, improving it is always a good goal. Here are some tips to do just that.

1. Access The Data in Your Niche.

There are some amazing data analysis tools that businesses are using as they make decisions regarding any number of things, inventory management being one of them.

Take the example of a bank. Now, it does not have physical products in its inventory, but it does have an inventory of credit card products. By using data analysis, it can dig deep into consumer behaviors and preferences regarding those. Also, analytics can predict which types of credit cards will be the most popular going forward. The bank can also use that data to evaluate the products, along with actual figures on the “sales” of their individual credit card products. They may then make decisions about which ones to eliminate and develop new products for their “inventory” that will sell better.

As analytics moves to the ranks of “commodity” technology, small business owners can also plug in a lot of affordable tools to run their numbers.

2. Consider Individualizing Your Inventory Turnover Ratios

Your overall turnover ratio gives you the big picture. But if you sell multiple products, the individual ratios of each of those products may tell a better story, especially if  you track them over a year’s time. While it is easy to walk through a warehouse and see too much inventory of particular products and it is also easy to track sales of specific products, even on a daily basis, it is also a good idea to get a longer-term view of those individual products.

For example, In March, you may see that a robotic vacuum is sitting on the shelf with few actual sales. The same in April. During the 4th quarter, however, sales pick up significantly, and they were flying off the shelves. Obviously, the holiday season was hot for this item. The “fix” for this is easy to see. Clearly, you should not order this product until the end of Quarter 3, and it will cease to be a cost liability.

3. Increase Consumer Demand for Your Inventory

Targeting specific low-performing products through marketing campaigns can assist to move inventory faster. But apart from ramping up the demand, you should also measure the cost you of your marketing campaigns against the increase in sales.

4. Encourage Customers to Buy Pre-Inventory Stock

Offer incentives to customers who will buy in advance. This helps to predict your inventory needs and purchases. And having inventory pre-sold means it moves out as soon as it arrives in your warehouse.

In fact, that’s how on-demand production works in case with T-shirt printing or producing other type of merch only after the purchase is made.

5. Consider Buying Smaller Quantities More Often

This is an option that may work very well, by not tying up cash that you could use for other business growth efforts. The downside, however, is that you may not have inventory in stock to meet purchases. Consumers do not like “back-orders.” But you may be able to find the right balance.

Certainly, your inventory turnover ratio is an important figure to calculate. It can give you an overall picture of how well you are moving your inventory. Plus, it points you in the direction of improving your inventory management practices and functions in other departments such as sales/marketing.

Photo by Bench Accounting

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