INVENTORY
TURNOVER
RATIO
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 turnover ratio should be compared with the following:
1) The industry average
2) It’s planned ratio
3) It’s 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.
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There are 2 formulas used for calculating inventory turnover ratio:
1. 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 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 he
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.
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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.
Industries holding high volume 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 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:
1 . The inventory is held in the warehouse for too long
2. Too much is purchased, i.e., overstocking has happened
3. Proper efforts are not being taken in the marketing or sales side
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?
1. Purchasing habit should be taken care of. Use a purchase order management software to
accurately track your purchases and forecast what will move better if purchased
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2. Use an inventory management software to get real-time updates of inventory. This will help
you avoid overselling, underselling and stock-outs.
3. Use proper warehouse management techniques. Very organized warehousing is essential to
know what exactly you have in stock and what not.
4. Use great marketing and sales techniques.
5. Focus on the top selling products- Stock more of the products that bring you more sales
than others and vice versa.
Wrong Purchase habits
Storage costs
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Bad sales
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Tu
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Inv
Adequate inventory purchased
Great Marketing & Sales
High Profits
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.
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Primaseller makes the entire process of inventory management and order processing easy
for retail and online sellers.
Do check out Primaseller and make way for easy and better business operations.
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