Inventory Turnover Ratio - FundsNet (2024)

In some cases, it can seem impossible to keep a product on the shelves, but in other cases, it may be impossible to get the products off of them.

Keeping track of how often a company has successfully sold its inventory and how frequently can help to determine pricing strategies, purchasing, and promotions.

This is where the inventory turnover ratio comes in.

This financial ratio tells how many times a company has sold inventory and replaced it in a given period of time.

There are multiple ways to calculate inventory turnover, and the resulting ratio can tell a lot about an organization’s inventory management, sales, and marketing.

With this information, management can help determine how to set a company’s course.

What Is Inventory Turnover?

Inventory turnover describes the amount of time that passes from when an item is purchased to the time it is sold.

A complete inventory turnover indicates that a company has sold all purchased stock minus inventory that was lost, such as that resulting from damage.

In general, successful companies will see multiple inventory turnovers every year.

However, this does vary by industry and the type of product.

General consumer packaged goods will typically have a high turnover ratio, while in contrast, many costly luxury goods will require long production times and see very low turnover rates.

There are also a number of difficulties that can affect inventory turnover.

Such challenges include changes in customer tastes, poor supply chain management, and overstocking of merchandise.

What Is the Inventory Turnover Ratio?

The inventory turnover ratio is a ratio that tells the number of times that a company has sold or used and replaced inventory over a given period of time.

With the inventory turnover formula, a company can also find the time it will take for the inventory on hand to be consumed.

The inventory turnover ratio can be found by dividing the cost of goods sold by the average inventory for the period.

Generally, companies want to see this result in a high ratio rather than a low one because this generally indicates strong sales.

In order to calculate the inventory turnover ratio, a company needs to know what stock it has on hand.

This requires companies to maintain an effective inventory control method in order to track this.

Understanding the Inventory Turnover Ratio

By calculating and recording the inventory turnover ratio, businesses can make better decisions in several ways.

This includes many aspects of the business, including purchasing or manufacturing of new inventory, pricing, and management of inventory.

The inventory turnover ratio ultimately represents how well a company performs at turning its inventory on hand into sales.

With this data, a business can make decisions to attempt to improve sales and marketing for certain products or to adjust the inventory it offers.

How Inventory Turnover Ratio Works

Generally, average inventory is used as a way to even out the increases and decreases in inventory that result from outlier changes that occur in a certain time period, like a week or month.

This means average inventory can produce a more steady and dependable measurement.

An example of this is the way that inventory for some items can significantly change seasonally, like Halloween costumes.

Stores will suddenly have a large inventory of Halloween costumes right before Halloween and then almost none after Halloween.

But, turnover can be calculated by taking the numbers from the ending inventory for the same accounting period that the numbers for the cost of goods sold were taken from.

The formula is also useful for calculating the amount of time necessary to sell any inventory that is on hand currently.

To calculate Days Sales of Inventory (DSI), this formula is used:

Average Inventory/Cost of Goods Sold * 365.

Calculating the Inventory Turnover Ratio (ITR)

Inventory can be calculated by using the cost of goods sold or market sales information and then dividing this by inventory.

This is a standard method of calculating inventory.

First, find the average inventory for the period.

This is done by adding the beginning and ending inventory together and dividing this by two.

Average Inventory = Beginning Inventory + Ending Inventory/2

Ending inventory can be used instead of average inventory for businesses that don’t have seasonal fluctuations.

However, it is preferable to have additional data points.

Therefore, take the monthly inventory and divide it by twelve.

Then, use the formula, and calculate the inventory turnover using the annual inventory.

Inventory Turnover Ratio = Cost of Goods Sold / Avg. Inventory

Using the Inventory Turnover Formula

There are a number of formulas that can be used to calculate inventory turnover, but whichever one a company chooses, they will need data from the balance sheet.

Therefore, it is essential to know the meaning of the terms on the balance sheet as well as what the numbers stand for.

Cost of Goods Sold (COGS)

This number shows the direct costs that it takes to produce goods that the company will be selling.

This number includes raw materials.

Average Inventory (AI)

Average inventory spreads out the inventory a company has over at least two specific accounting periods.

Average Inventory = Beginning Inventory + ending inventory/number of months in the accounting period

Inventory Turnover Ratio

This ratio indicates the number of times a company’s inventory is sold and then replaced over a certain period of time.

Inventory Turnover Ratio = Cost of Goods Sold / Avg. Inventory

Examples of Inventory Turnover Ratio

Let’s look at an example.

The Sweater Shop sells hand-knitted sweaters by order.

The store’s best time of year is the third quarter.

The store had a cost of goods sold of $40,000 and an average inventory of $20,000.

The business’s inventory turnover ratio would be found by dividing $40,000 by $20,000.

This would give The Sweater Shop an inventory turnover ratio of 2.

For another example, the average inventory period for The Sweater Shop will be calculated.

This is a calculation of how long it would take to sell the store’s current inventory.

To do this, the days in a year are divided by the inventory turnover ratio for the store. (365/2 = 182.5) This results in an average inventory period of 182.5 days.

So, it should take 182.5 days to sell all of the store’s current inventory.

Why Does Inventory Turnover Matter?

Inventory turnover is an important performance indicator that can help companies to make better decisions in several respects.

Low turnover may indicate that market demand has declined for certain goods.

Knowing this can help companies to make decisions such as reducing the pricing of certain products, creating special incentives such as sales, and potentially changing their product mix.

These are critical decisions for every company to make in order to offer the right products at the right price to align with customer demand.

Important Inventory Management Factors to Consider

There are a few different factors that can throw off an otherwise effective inventory management system.

Here are three of them to keep your eye on.

• Who Dictates the Price: When the manufacturer of a product dictates a minimum or maximum price that a good can be sold for, that greatly limits the ability to adjust the price in order to manage turnover.
• Guaranteed Minimum Purchases: A company may tie up working capital by guaranteeing minimum purchases from their suppliers. However, it can also prevent supply chain disruptions that can result in inventory shortfalls.
• Prevent Over-Stocking: The cost of storing merchandise often referred to as carrying costs, can quickly add up for excess supplies. These expenses include renting warehouses, transporting the merchandise, taxes, and insurance.

A fast turnover may simply indicate strong sales performance; however, it could indicate that a company’s inventory purchasing is failing to keep pace with market demand or that there is an issue somewhere in the supply chain.

Understanding the causes of a fast turnover will help a company to make decisions on whether or not to increase the price of certain goods, increase inventory purchases, add new related inventory, make changes in its suppliers, and increase marketing for certain products.

What Is the Best Inventory Turnover Ratio?

In general, the higher an inventory ratio number is, the better because it most commonly indicates strong sales.

A low inventory turnover ratio, on the other hand, can indicate poor sales and dropping market demand for certain goods.

This is not a universal rule, though, as some goods may ordinarily have a low inventory turnover ratio.

This includes costly, high-end goods such as designer clothing and jewelry, which are not purchased regularly.

There is also a limit to how high an inventory ratio can be before it likely indicates that inventory is not being purchased in a suitable quantity to meet the current rate of demand.

This may mean that a company is missing out on potential sales as well as profits.

By raising prices and ensuring suitable inventory, the ratio may drop while simultaneously raising profits.

Inventory Turnover Differences by Industry

Inventory turnover can vary a lot depending on the industry the company is in.

Businesses that typically have a high volume of sales with a low margin generally have a high inventory turnover ratio.

In contrast, businesses that typically have a low volume of sales but a high margin generally have a low inventory turnover ratio.

An example of this would be Debbie’s Ice Cream Castle that sells a large quantity of ice cream treats with a low margin.

So, Debbie’s ice cream treats has a high inventory turnover ratio.

In comparison, Dave’s Handmade Rugs sells high-end custom rugs.

His rugs are expensive, and he sells a small number of rugs with a high margin.

Therefore, Dave’s Handmade Rugs typically has a low inventory turnover ratio.

Effective retail inventory management isn’t easy and requires knowledge of profit margins, seasonality, sales margins, as well as some other important factors.

Some retailers like to use a method called cost-to-retail, which is a vertical-specific inventory method.

This method estimates the value of the ending inventory by utilizing the ratio of the cost of the inventory to the retail price.

High and Low Inventory Turnover Ratios Explained

How to Deal with a Low Inventory Turnover Ratio?

If a business has a low inventory turnover ratio, it’s important to find out why.

This could mean other businesses have lower prices, and if this is the case, it might be a good idea to reconsider pricing.

It may also be a matter of consumer demand for the goods.

This may require a change in the products offered. It’s also possible that purchasing policy and processes are in need of some changes if inventory tends to pile up.

It might be a good idea to consider tying up less capital in inventory.

Another possibility is salespeople.

If they are not performing well, they may need additional training.

Additionally, make sure sales leaders are instructed to make realistic projections.

Why Is a Higher Inventory Turnover Ratio Generally Preferred?

Typically, management and investors prefer a higher inventory turnover ratio because it means that a company’s stock is being depleted due to high sales.

In general, this is good news for a company.

However, this could indicate that other steps should be taken.

One possible explanation for a high turnover ratio is that the market demand for a certain good is high, in which case the company may want to consider increasing the size of its orders for goods.

It may also mean that a company is failing to buy enough inventory creating a limit on sales.

This means an opportunity to increase sales by purchasing more stock.

Can an Inventory Turnover Ratio Be Too High?

Yes, it definitely can be.

If an inventory turnover ratio is extremely high, generally somewhere around ten or more, then it means that sales are being hampered by an inventory that is too small.

New stock generally requires time to be delivered and prepared for sale.

This means wasted time and opportunity. In these cases, a company should attempt to raise the quantity of inventory they are purchasing to achieve a lower and more profitable turnover range.

The Ideal Inventory Turnover Ratio

The ideal inventory turnover ratio is different for every company and industry; however, most of the time, the ideal ratio will fall somewhere between 5 to 10.

This equates to a company selling and restocking its inventory approximately every 1-2 months.

For companies that deal primarily in perishable goods, this number may be higher to avoid spoilage, and in businesses dealing with particularly expensive merchandise, this may be lower.

How Else Can a Company Use the Inventory Turnover Ratio?

The inventory turnover ratio can be used in several ways to improve a company’s management of inventory, product pricing, supply chain management, and marketing strategies.

With proper use, this ratio can play an important role in a company’s success.

Three of the most common uses include:

• Identify Upcoming Sales Trends: Inventory turnover ratios are one of the most effective ways to identify emerging trends in market demand. Whether it is increasing demand for a certain product or inventory that is becoming obsolete, a company can get an idea of whether or not to increase or reduce the stock of a certain good. This provides far more control over inventory and the opportunity to take advantage of new opportunities.
• Compare SKUs and Segments: Many companies use the inventory turnover ratio to compare inventory and measure it at either the stock-keeping unit (SKU) or be segmenting inventory into specific classifications. By segmenting products into certain categories that make sense for specific company management can compare certain categories of products to see how they are performing versus others they that offer. It could also be separated based on geography to compare different locations of retail outlets.
• Identify Loss Leaders: Many businesses rely on the Pareto principle or 80/20 rule to guide inventory and sales decisions. This principle states that 80% of a company’s sales will be driven by 20% of its inventory. By identifying these products, a company can deliberately price them low to bring customers in. From here, they may be enticed to buy more profitable inventory. To take advantage of this, a company must use the inventory turnover ratio to identify these products and then plan to keep a healthy supply of them on hand.

Five Techniques to Optimize Inventory Turnover

The primary way to upgrade a company’s inventory turnover ratio is to improve its inventory management.

There are five ways to do this.

Streamline Supply Chains

Choosing the cheapest suppliers is not always the best strategy.

For products that are central to a company’s offerings or that are seeing an increase in demand, and improved or guaranteed delivery time can justify an increase in expense.

Additionally, simply streamlining logistics can eliminate wasteful inefficiencies and benefits sales and profit margins

Adjust Product Pricing

By raising prices on high-demand items, profit margins can be increased, and by lowering prices on low-demand items, unpopular or obsolete inventory can be moved out for items that simply can’t seem to be sold charitable donations or alternate offloading techniques to reduce carrying costs.

Improve Industry Ranking

By managing inventory turnover in relation to a company’s peers, it can help identify emerging opportunities.

By identifying competitive items and strategically managing inventory, a company can increase its market share and rankings within an industry.

Improve Inventory Forecasting

By utilizing sales and inventory turnover data, a business can often greatly improve its inventory forecasting.

This may also identify opportunities to alter its overall product mix and introduce new sales strategies such as bundling certain products, potentially improving profit margin as well.

Automate Purchase Orders

Automating processes such as purchasing inventory can increase efficiency and will often lead to reduced expense.

However, by using it with an effective order management system, a business can ensure that fast-moving inventory is always on the shelf preventing lost sales.

Additionally, if you use an inventory system that will automatically generate your business’s purchase orders, your buyers will be able to look them over and point out any errors.

Key Takeaways

• Inventory for the purposes of this ratio includes all stock that a company intends to sell.
• Inventory turnover refers to the rate at which stocked inventory is sold and replaced.
• A high inventory turnover ratio generally points to strong sales and a low one too weak sales. However, a high ratio may also indicate insufficient inventory on hand, and a low ratio may indicate overstocking.