Inventory Turnover Ratio: What It Is & How To Calculate It?
If you run a small retail company, you are aware of the significance of effective inventory management. The bottom line of your company depends on every item you carry and every square foot of your retail area. The amount of profit or loss that is displayed on your balance sheet at the end of every month, quarter, or fiscal year depends on the products you decide to offer for sale, their value over cost, and how quickly you are able to move those products through your store and into the hands of your customers.
It’s astonishing to see how few retail small company owners have the proper system in place to manage the movement of their inventory—known in accounting as the “inventory turnover ratio“—given that controlling inventory has such a huge influence on any retailer’s long-term profitability.
Here is all the information you need to manage your inventory turnover as a retail firm and to understand the inventory turnover ratio.
What Is the Inventory Turnover Ratio?
The inventory turnover ratio is a measure that contrasts the cost of goods sold with the average value of inventory over the course of an accounting period in a company’s financial statements. For calculation, we can use the following Inventory Turnover Ratio Formula:
Average Inventory Value/Cost of Goods Sold = Inventory Turnover Ratio
The cost of producing a company’s goods is measured by its cost of goods sold (COGS). COGS only takes into account direct expenses, such as the cost of the raw materials used to create the product, and ignores indirect costs, such as those associated with selling or marketing the product. The average inventory value is the average cash value of the company’s on-hand inventory over a certain period of time. An inventory turnover ratio may assist company owners in calculating how often they sell out and replenish their whole inventory over a certain time period.
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How to Determine the Cost of Sales (COGS)
Add the value of the inventory you had at the start of the time period to any purchases you made to produce additional inventory to determine the cost of items sold during that time period. The sum should then be reduced by the inventory’s value at the conclusion of that time period. The COGS equation is:
COGS = Beginning inventory + Purchases-Ending inventory
Depending on changes in inventory, the cost of manufactured or purchased commodities is changed. For instance, the cost of 450 units would be the cost of products sold if 500 units were produced or purchased but inventory increased by 50 units. The cost of 550 units is the cost of goods sold if inventory falls by 50 units.
Methods for Determining the Average Inventory Value
Add the starting and ending inventory values together, then divide by two to get your average inventory value. The equation for average inventory value is:
Average inventory value = (Beginning Inventory Value + Ending Inventory Value) / 2
For instance, a small firm selling sweatshirts would divide the sum of its starting and ending inventory values ($20,000) by two to arrive at a total of $10,000 if it wished to determine its average inventory value for the quarter of the year.
Inventory turnover ratio example
Let’s assume that to continue with the example of the sweatshirt company, the company also determines its inventory turnover percentage on a quarterly basis. They would divide the average inventory value for that quarter ($10,000) by the COGS ($40,000) to get an inventory turnover ratio of 4.
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The Importance of Inventory Turnover Ratio
Inventory turnover ratios are used by both manufacturers and merchants for a variety of forecasting techniques.
1. Sales forecasting
With reliable data, inventory management software can estimate how long it will take a business to sell its current inventory. It is also possible to calculate days sales of inventory (DSI) by dividing the average inventory value by COGS and multiplying the result by 365.
2. Inventory management
To keep up with customer demand, a company that has a high inventory turnover rate may need to increase the quantity of goods and raw materials it purchases from suppliers. To prevent overstocking and the high storage expenses that come with it, it may need to reduce its inventory balance if it has a poor inventory turnover ratio.
3. Cash flow
To estimate cash flow on a balance sheet, organizations might use an inventory turnover ratio. A company can forecast its future cash on hand when inventory turns over at a consistent pace.
4. Pricing strategy
If a business has a surplus of inventory, it may need to reduce prices in order to increase the inventory turnover ratio. Due to depreciation and obsolescence, having an excessive quantity of inventory may be expensive.
Modern accounting software makes it straightforward to determine the inventory turnover ratio for any time period, even though it is often calculated on a monthly or quarterly basis.
How to Read an Organization's Inventory Turnover Ratio
You may learn a lot about a company’s stock turnover and supply chain by taking a fast look at its inventory turnover ratio.
1. High inventory turnover ratio
If the firm has a high inventory turnover ratio, it suggests that its in-stock merchandise is used rapidly. It depends on a strong supply chain to ensure that products continue to flow into its shops and warehouses.
2. Low inventory turnover ratio
A low inventory turnover ratio indicates that a company retains its inventory for a considerable amount of time. Since unsold goods may degrade over time, a very low inventory turnover rate may indicate that inventory management is required.
A ratio of inventory turnover cannot always predict profitability. Compared to other businesses, some have inherently lengthy turnover cycles and low benchmark ratios, such as high-end jewelry and designer furniture. These sectors, however, may be just as financially sound as a chain of supermarkets with a lightning-quick inventory turnover rate since they operate at high-profit margins.
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Conclusion
The inventory turnover ratio is a crucial KPI for evaluating the success of your whole company. It is a reliable sign of how well your business understands its market and how effectively the sales and procurement teams work together.
If sales are sluggish and there is extra inventory tying up cash, inventory turnover is often low; on the other hand, if inventory turnover is high, inventory is depleting quickly, which might be a positive thing or a sign of frequent stock-outs.
By monitoring and evaluating your stock movements and choosing the appropriate ratio individually for your business, you may discover the perfect inventory turnover rate. You may fine-tune your inventory turnover by defining a target and then using sales, marketing, procurement, and inventory management techniques.
FAQs
1. Is high inventory turnover good or bad?
The better the inventory turnover, since it often indicates that a firm is selling its items rapidly and that there is a big demand for them.
2. What is the purpose of the inventory turnover ratio?
The method may also be used to determine how many days will pass until the current inventory is sold.
