The inventory turnover ratio is the most important component of inventory management. Whenever there is talk about inventory, you should take precautionary steps so that the rate of loss can be minimized to a certain level. There can be many instances when companies face irregularities with their inventory because of miscalculations of the average inventory and inventory turnover ratio that is supposed to be maintained throughout an accounting period.
In this article, we have discussed everything you need to know about the inventory turnover ratio like its formula, tips, examples, limitations, calculations, and more. Keep reading to know all that you need to, on this topic.
What Is Inventory Turnover?
To explain in simple terms, inventory turnover reveals the number of times your inventory is sold during a certain time frame in relation to its cost of goods sold (COGS). Using this, you can easily determine the rate at which you require inventory for sale before the end of a month.
Basically, inventory turnover is a metric that measures how often a company replaces its inventory. To calculate it, you need to divide the COGS by the average inventory for the specific time period. It tells you how good the company is at managing its inventory.
Companies involved in consumer durable goods generally have a higher inventory turnover due to high demand for their products. However, the companies that produce luxury goods are known to produce at a lower inventory turnover because of low demand for their products and higher production time.
What Is Inventory Turnover Ratio?
The inventory turnover ratio tells you how fast the company replaces its inventory by converting it to sales.
You can use the formula of inventory turnover ratio to find out how many days it would be required for your business to sell out the total inventory in hand. The formula of inventory turnover ratio is the total cost of the goods sold (COGS) divided by the average inventory.
By knowing the inventory turnover ratio, you as a business owner can decide better when it comes to pricing your products, manufacturing them, as well as marketing or buying them.
A low inventory turnover ratio indicates fewer sales and excess inventory, and a higher inventory turnover ratio indicates the company has been generating sales at a greater number.
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Inventory Turnover Formula and Calculation
Before you hop onto the details of the formula to calculate the inventory turnover ratio, you must understand the terms included in the formula.
- Cost of Goods Sold (COGS): Cost of goods sold or COGS is the total cost incurred by the company for directly selling its products.
- Average Inventory (AI): Average inventory is the method through which a company eases out the calculation by dividing the total number of inventories in hand by consecutive periods.
- Inventory Turnover Ratio Formula: Inventory Turnover ratio = cost of goods sold / average inventory
Using this formula of inventory turnover ratio, your business would be able to find out the actual stock limits on which it has been operating through an end of an accounting year.
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How Does Inventory Turnover Ratio Work?
The inventory ratio works in a simple manner. First of all, the average inventory is used to find out the stock in the business or the number that has been emptied before new inventory could be brought upon based on a few months or days.
Therefore, using the formula of average inventory, you can understand quite a few things about your business comprehensively. However, when it comes to seasonal fluctuation, a common occurrence for a business, the calculation of average inventory falls slightly short of its accuracy.
That is when the calculation of the inventory turnover ratio comes into the picture, which considers the total cost of goods sold and divides it by the number found from the average inventory. Moreover, using this inventory turnover ratio, your business can also calculate the total time that your company would take to sell out all the inventory that is still present in hand.
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What Does Inventory Turnover Ratio Indicate?
A company can use an inventory turnover ratio to indicate how well it has been able to perform the sales of all products in its inventory while also keeping in mind its total cost. In simple words, a higher inventory turnover ratio would mean the business has been able to perform quite efficiently compared to those who have a lower inventory turnover ratio.
Whenever a business reveals a low inventory ratio, you can easily determine that it has been unable to convert its inventory into cash by not being able to sell the products before the next inventory cycle. This would also mean that overstocking has occurred in that specific accounting period.
Inventory Turnover and Dead Stock
Inventory turnover is a very important metric used to determine the data of all the products a business has sold by calculating the cost of goods sold and average inventory. In most cases, the inventory turnover of companies selling fashionable clothes, various types of groceries, and automobiles is high.
However, when your company has incorrectly purchased a higher number of a particular product that is lying in the inventory for months, it will lead your business to face huge losses. Such stock that has remained unsold by your business is termed dead stock.
Related Inventory Ratios
There are two categories of inventory turnover ratios: inventory to sales ratio and days sales of inventory (DSI).
- Inventory to Sales Ratio: The inventory-to-sales ratio is slightly different from the inventory turnover ratio, or rather you can say it is inverse to it. This ratio uses the net sales value for calculation rather than the cost of sales to find out the total value of inventory.
- Days Sales of Inventory (DSI): Among all the other ratios used by the company for finding out information about its inventory, the days' inventory sales are considered the most popular. It uses the average value of inventory, divides it by the total cost of sales, and multiplies it by 365 to find the total value of the ratio.
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Importance of Inventory Turnover Ratio
The inventory turnover ratio plays a key role in changing the fortune of a company in the market.
1. Inventory Turnover for Slow Moving Products: When the inventory turnover ratio is low, it indicates that products are moving slowly. To address this, consider adjusting the pricing strategy or offering additional incentives to customers. This helps in clearing out inventory more quickly and ensures the financial health of the company while meeting customer demands.
2. Strategic Changes for High Turnover: On the other hand, a high inventory turnover ratio means products are selling quickly, but it could also indicate that the company is running out of products while demand is still high. In this situation, evaluate whether to increase the prices of existing products or order more stock to maximize profits. 3. Balancing Inventory Levels: The key is to find a balance that ensures the company is not holding onto inventory for too long, while also not running out of products when they are in demand. This balance is crucial for maintaining financial stability and customer satisfaction.
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What Is the Best Inventory Turnover Ratio?
According to the industrial requirements, the best inventory turnover ratio is considered to be high, indicating the business has sold the goods efficiently. While a lower inventory turnover ratio indicates that the company hasn't been able to properly convert all of its inventory into sales.
However, such instances are not always true because whenever your company goes through high inventory turnover, it may also mean the organization hasn't been able to properly manage its inventory to use the demand in the market for its benefit.
An even greater amount of profit could be generated by your company when it starts to exploit all the demand that is present in the market for a particular product that is available in your inventory. The most beneficial thing for you to do in such instances would be either order more inventory for your company or increase the rate at which you sell your products.
What Should I Do About Low Inventory Ratio?
If your company is experiencing a low inventory turnover ratio, it might be time for your business to thoroughly analyze its inventory control mechanisms and deploy some inventory turnover measures.
First of all, you should find out whether your competitors in the market are offering products at a lower rate, then you should start strategizing about the new price of your products.
Secondly, you should find out whether the demand for the products offered by your company is waning away from the market.
After researching, if you find such a scenario has taken place, removing those products from your inventory by offering them at comparatively lower rates would be a smart choice.
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Why Is a Higher Inventory Turnover Ratio Better?
A higher inventory ratio, in most cases, is considered a much better scenario than a lower one because a higher inventory ratio means your business has been able to convert the majority of its inventory into sales using existing methods.
A higher inventory turnover ratio also means reduced holding costs, more cash flow, and high customer satisfaction.
Most importantly, a high inventory turnover ratio means that the company is able to quickly fulfill customer orders by ensuring optimum stock levels. This results in increased customer satisfaction and repeat business.
How Else Can Inventory Turnover Ratio Be Used?
The inventory turnover ratio is a versatile tool that helps businesses in market trend analysis, industry benchmarking, supply chain optimization, working capital management, future sales forecasting, and identifying profitable stock-keeping units (SKUs).
1. Deciphering Market Trends:
- What It Does: Helps in identifying prevailing market trends.
- Benefits: Enhances overall business operations.
- Application: Decide on scaling inventory up or down based on market conditions to optimize costs.
2. Benchmarking with Industry Best Practices:
- What It Does: Allows comparison of your inventory turnover ratio with peers.
- Benefits: Uncover industry trends and best practices for growth.
- Application: Implement effective strategies to align with industry standards and boost business growth.
3. Identifying Supply Chain Inefficiencies:
- What It Does: Highlights areas of improvement in the supply chain.
- Indicator: A low inventory turnover ratio signals inefficiencies.
- Application: Address issues like overstocking and insufficient marketing to enhance the supply chain and inventory turnover ratio.
4. Managing Working Capital:
- What It Does: Assists in calculating working capital needs.
- Benefits: Frees up working capital when inventory turnover ratio is high.
- Application: Allocate freed-up capital for business growth or other expenses.
5. Forecasting Future Sales:
- What It Does: Serves as a metric for projecting future sales.
- Benefits: Informs decision-making in production, marketing, and sales.
- Application: Analyze past inventory turnover trends for better future sales predictions.
6. Focusing on Profitable SKUs:
- What It Does: Helps identify the most profitable stock-keeping units.
- Based On: The 80/20 rule, where 20% of SKUs contribute to 80% of sales.Application: Concentrate marketing efforts on these profitable SKUs and decide which products to retain or remove from inventory.
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Can Inventory Turnover Ratio Be Too High?
An excessively high inventory turnover ratio should not always be trusted upfront, as it might not show the true picture of the business. It also indicates that a company may be experiencing inventory stockouts, which can lead to lost sales and reduced customer satisfaction.
A high inventory turnover ratio can also mean that a company is not holding enough inventory to meet customer demand and is constantly ordering and restocking inventory, which can result in higher ordering and transportation costs.
Ideal Inventory Turnover Ratio
The ideal or standard inventory turnover ratio is anything around 5 to 10. If your business also projects these numbers in its inventory ratio, it is smooth sailing through the market compared to others. Moreover, it means that your business is selling off all of its inventory before the end of an accounting period, as necessary.
Limitations of Inventory Turnover Ratio
We have seen several inventory turnover ratio formula examples above which are beneficial for businesses. However, there are some key limitations of the inventory turnover ratio that you must know, to obtain a more complete picture of your company's financial health. Let's take a look.
- Inventory turnover ratios vary widely by industry so if you compare the inventory turnover ratio across sectors, the results would mislead you.
- Industries that have seasonal demand have varying inventory turnover ratios. For instance, during festive seasons companies that sell related items have high inventory turnover ratios, but it does not indicate that in all months those companies have high sales.
- When we use different costing methods, the inventory turnover ratio will vary.
- If a company has inventory quality issues, the ratio may be inflated as it may need to sell off the inventory at a discount or write it off entirely, resulting in a lower cost of goods sold.
- The inventory turnover ratio does not take into consideration slow-moving inventory, which may be obsolete or outdated, but still sitting on the shelves.
- If a company sells inventory through multiple sales channels, the inventory turnover ratio will not reveal the actual efficiency of inventory management for each channel.
- This inventory turnover ratio could only provide you with the number of items sold by your business and not explain the reason or details behind the growth in the ratio or loss throughout a particular financial period.
Inventory Turnover Optimization Techniques
When it comes to inventory turnover optimization techniques, there are five ways you can use them depending on the requirement of your business.
Product Pricing
The price of your products could either attract more customers to your business or repel them away depending on whether the price is low, affordable, or too high. Adjusting the price of your inventory depending on its demand could help you optimize inventory turnover.
Enhanced Demand Forecasting
Accurate forecasting of demand is important to ensure there is no overstocking or understocking of inventory. When demand forecasting is done accurately, businesses are able to optimize their inventory levels perfectly to meet customer demand without holding onto excess inventory.
Through forecasting, your business would be able to find out which products need to be brought into the inventory more often and which ones should be omitted from the business inventory.
Regular Inventory Audits
By carrying out inventory audits regularly, businesses get the true picture and ensure that inventory levels are accurate and up-to-date. Audits help to identify and correct discrepancies, ensuring that businesses are not holding onto unnecessary inventory and can prevent stock-outs.
Implementing Inventory Management Software
With the help of software, businesses can automate many inventory-related tasks like placing the necessary orders, reducing the risk of errors, and streamlining inventory management processes. Inventory management software can help businesses track inventory levels, forecast demand, and manage orders more efficiently.
Streamlining Supply Chain
Your suppliers contribute significantly to the profit generated by your business. Maintaining good relations with suppliers can increase your chances of getting better rates for products, along with a higher quality of goods.
However, if the suppliers are unable to deliver upon their promises, then it could be time for you to streamline the supply chain of your business to increase the sale and profit accumulation at the end of each financial year.
Optimizing Inventory Turnover With Inventory Management Software
As a business, if you choose to use inventory management software, you might be able to restructure the policies and processes laid down for effective inventory management. When you choose to use an automated inventory management software system, all your inventory-related tasks will be simpler and error-free as the beginning.
Moreover, with inventory management software, you can easily track all the sales in your business while also looking into the inventory depletion and stocks that need to be reordered for your business. Furthermore, suppose you incorporate an ERP system alongside the inventory management software, you can streamline the whole supply chain process by establishing a better outlook on every part of the inventory.
Choose TranZact Cloud ERP for Inventory Management
When inventory is managed well, businesses can benefit from improved inventory metrics. From optimal inventory levels to order accuracy and reduced lead time to accurate inventory costs everything is on track. Most importantly, businesses are able to reduce associated costs, enhance cash flow, and increase profitability and competitiveness.
If you want to streamline your inventory management to increase the inventory turnover ratio, TranZact blogs/cloud-ERP would be the best fit for your needs. Schedule a call today!
FAQs on Inventory Turnover Ratio
1. What is a good inventory turnover?
A good inventory turnover for most companies hovers around 5 to 10, which means the company has successfully sold out its inventory within one or two months.
2. Is higher inventory turnover good or bad?
The higher inventory turnover ratio is considered good for most businesses as it means the company has been able to sell most of its products before the end of an accounting period. This depends on several other factors based on the accuracy of stock analysis and demand forecasts.
3. What increases inventory turnover?
Incorporating a few valuable strategies like reducing the reorder quantity and the level of stock while implementing various marketing campaigns can boost your inventory turnover.
4. What happens when the inventory turnover ratio decreases?
A decrease in the ideal inventory turnover ratio means your business is unable to sell all its inventory before the end of an accounting period.
