Inventory turnover ratio formula explained
16 Jul 2021
Understanding inventory turnover is a crucial step towards solid business performance. It would not be an exaggeration to state that the stock movement through the supply chain is the essence of the business for many companies. Inventory movement operations are one of the primary measures of future business success. One of the gauges of that movement is the inventory turnover ratio. It shows how well a company manages inventory that comes from suppliers and moves through the supply chain.
What is inventory turnover?
Inventory turnover, or inventory turnover ratio, is used to calculate the rate that the company replenishes its stock of goods during a specific period due to sales. So, generally speaking, the purpose of the inventory turnover rate is to assess a company’s performance from the point of generated sales. It takes the cost of goods sold relative to the average inventory of some period.
The inventory turnover ratio improves different business decisions, including those referring to pricing, production, procurement, and marketing activities. To assess the competitiveness of the business, the ratio can be compared to the ones of previous periods, estimated and planned ratios, and industry averages.
How to calculate and interpret the inventory turnover ratio?
So, the inventory turnover ratio shows the amount of inventory sold over a specific period. To calculate the ratio, the cost of goods sold (COGS) is divided by the average inventory of the same timeframe.
Inventory turnover = COGS / Average inventory
- COGS = Cost of Goods Sold
- Average inventory = (inventory at the beginning of the period + inventory at the end of the period) / 2
The ratio uses average inventory to calculate the inventory turnover ratio because companies might have high fluctuations at certain times of the period. By averaging the amount, the business will get a more accurate ratio.
Cost of goods sold refers to the direct and indirect costs that occur while producing and selling goods. It can include the cost of materials, labor, factory overheads, shipment, etc.
Company M is operating in the automotive industry. According to the income statement of the last financial year, M reported costs of goods sold of $1,000,000. As you can see in the balance sheet, the opening inventory was $2,000,000, and the ending inventory was $3,000,000.
So, putting these data in a formula, we get the following:
Inventory turnover ratio = $1,000,000/($2,000,000+$3,000,000)/2 = 0.4
The turnover rate is 0.4, which means that M sold almost half of its inventory during the financial period. It also means that it would take M more than 2 years to sell the whole stock or complete one turn. Whether this is a good image or not depends on the industry characteristics.
If the ratio is low
So, the inventory turnover ratio estimates the speed at which the company sells its inventory. A low ratio indicates that the sales are weak or the inventory levels are probably higher than required, known as overstocking. The reasons for the low inventory turnover ratio can be very different. It can be the quality or choice of goods, or it can result from ineffective marketing or of its absence.
If the ratio is high
If the inventory turnover ratio is high, it can either indicate strong sales practices or a low inventory level, also called understocking. The best scenario is when good sales volumes cause a high inventory ratio. On the other hand, if the ratio is high because of understocking, the business might lose potential sales.
The rate at which a business sells its stock is a crucial measure of its performance. The longer inventory is held, the higher its handling costs and the risks associated with the deadstock. Thus, when it is considered that the companies which move out the stock faster tend to outperform competitors.
The inventory turnover ratio is a valuable assessment tool to estimate how well a business turns its inventory into sales. The ratio also indicates how well the management controls costs associated with stock and if they are ordering adequate inventory levels to avoid over and understocking.
The ratio is an indicator of the company’s sales performance. If the sales are low or the economy is not performing well, the business will show a low inventory turnover ratio. Since a generally higher turnover ratio indicates that there are more sales from a particular inventory volume, it is preferable. So it indicates high liquidity and financial strength. Another benefit of a high ratio is that it reduces the risk of inventory theft, damage, or obsolescence.
However, there can be cases when a high ratio means lost sales because of understocking. Like other financial performance ratios, this inventory turnover ratio should be compared to industry benchmarks to assess whether the business performs well or poorly.
How to optimize inventory turnover?
There are many practices that a business can use to improve the inventory turnover ratio:
- Increase the customer demand for the goods through correctly targeted, cost-effective, and well-developed marketing campaigns and promotions.
- Regularly examine and update the pricing strategies and analyze what will generate high sales volumes.
- Continuously review the prices on which you obtain goods from vendors and consider asking for discounts when placing an order.
- Thoroughly analyze and understand your top-selling goods and stock inventory that sells
- Improve forecasting accuracy for better inventory management and monitoring. Consider checking this guide for inventory forecasting.
- Develop pre-ordering practices for goods and encourage your clients to choose that option as well.
- Analyze and eliminate slow inventory to ensure that it does not hold valuable space in your warehouse.
To sum up
In conclusion, any company for which inventory is one of the primary assets must be aware of its inventory turnover ratio and take actions to improve or maintain it at the desired rate.