The concept of turnover in inventory management refers to how quickly inventory is sold. The inventory turnover ratio is used to assess how well a business manages purchasing from suppliers, allocating raw materials for production, and selling finished goods.
The inventory turnover ratio is one of the most important measures of a business’s financial health. It is used to gauge how efficiently a business manages its inventory and highlights any inefficiencies in its processes or problems with stock demand.
Calculating the Inventory Turnover Ratio
To calculate the inventory turnover ratio, you need to divide the cost of goods sold during a given period by the average inventory for that same period.
To get the inventory turnover ratio, the cost of goods sold (COGS) is divided by the average inventory:
Cost of Goods Sold / Average Inventory = Inventory Turnover Ratio
Before calculating the inventory turnover ratio, though, you must first calculate the average inventory in a given period. You can get this value by dividing the sum of your beginning and ending inventory by two.
(Beginning Inventory + Ending Inventory) / 2 = Average Inventory
A higher inventory turnover ratio generally indicates better financial health, as it shows that the company has fewer unsold goods on hand and can more effectively move its product in and out of inventory.
On the other hand, a high inventory turnover ratio could also mean that a company was unable to meet the increased demand and therefore missed out on potential sales — so analysis and context are always important.
Conversely, a lower turnover ratio may indicate the company is having difficulty selling its goods or keeping its stock levels in check. The ideal inventory turnover ratio varies, since each business has unique goals, objectives, and figures. The determining factors include the size of your organization, cash flow, and the speed at which you can sell your assets, as well as the kinds of products you sell.
The recommended inventory turnover ratio for most industries is 5 to 10. This indicates that the company sells and replenishes its stocks every one to two months. However, industries dealing with perishable products should aim for an even higher ratio to minimize losses due to spoilage.
Why the Inventory Turnover Ratio is Important
The inventory turnover ratio gives business owners insight into their day-to-day operations and can help them identify areas where they may need to improve efficiency. It can also benefit a company in several ways, such as:
Accurate Estimates for Stocking
If a business keeps too much inventory, it risks not having enough money to pay employees, bills, suppliers, and lenders if some items don’t sell. To avoid this, they can use the inventory turnover ratio to determine the amount of inventory to replace, instead of overstocking.
Reduce Expenses
If a company can accurately calculate its inventory needs, it can reduce its costs. This includes the cost of renting storage space, insurance, and staffing to manage and move the goods. With an accurate inventory turnover ratio, companies can also ensure they don’t purchase too much raw material or overproduce finished goods that could go unsold.
Improved Cash Flow
When companies can accurately estimate the amount of inventory they need to purchase, it allows them to better manage cash flow and avoid raising additional capital or taking out loans. This also helps reduce their overall expenses, allowing them to re-invest any savings into other business areas that could help grow and expand it.
Keeping Track of Inventory Over Time
The inventory turnover ratio can also be used to track the performance of a company over time. By comparing one year’s inventory turnover ratio to that of the previous year, it can help business owners identify any areas where they need to improve efficiency, or identify any trends in their sales and purchasing patterns.
Overall, the inventory turnover ratio is an essential tool for any business looking to optimize its inventory management and ensure financial stability. By using this ratio to accurately estimate the amount of inventory needed, businesses can reduce their expenses and improve cash flow while also gaining insight into how efficiently they’re managing their stock.