Inventory turnover ratio is a crucial metric that measures how efficiently a company is managing its inventory. It calculates the number of times a company sells and replaces its stock over a particular period. A high inventory turnover ratio indicates that the business is selling its products quickly, which in turn means it is generating more revenue and profits. On the other hand, a low ratio implies that the company has excess inventory, which can tie up funds and increase storage costs.
Every business owner wants to maximize their inventory turnover ratio as it directly affects their profitability. However, achieving this goal can be challenging, especially in today's highly competitive market. In this article, we'll discuss some effective strategies to improve your inventory turnover ratio and boost your bottom line. By implementing these tactics, you can streamline your operations, reduce waste, and increase sales, resulting in better cash flow and higher profits.
How to Calculate Inventory Turnover Ratio (Step-by-Step)
The inventory turnover ratio portrays how efficiently a company is managing its inventory. This metric determines the number of times the entire inventory has been sold and replaced during a matching period. To calculate this, it is necessary to divide the cost of goods sold (COGS) by the average inventory balance.
To get started, gather information on your inventory purchases for a specific period and determine the cost of goods sold (COGS). Next, calculate the average inventory by adding together the prior period's ending inventory and the current period's ending inventory, then dividing that number by two. Finally, divide COGS by the average inventory to arrive at your company's inventory turnover ratio.
Keep in mind that there are different ways to calculate this ratio depending on whether your business deals with finished goods or raw materials. Regardless, knowing your company's inventory turnover ratio can help you identify areas where you may need to adjust your operations for greater efficiency.
Inventory turnover ratio formula and calculations
Inventory turnover ratio is a financial metric that measures the number of times a company sells and replenishes its inventory within a given period. The inventory turnover ratio formula calculates the average time inventory is held before it's sold, and it is calculated by dividing the cost of goods sold by the monthly average inventory. To calculate the monthly average inventory, add up the total starting inventory for each month of the financial year and divide by 12.
For instance, if a high-end bicycle manufacturer has $4 million in cost of goods sold and $550,000 in average inventory, their inventory turnover ratio would be 7.27 times per year, or approximately 50 days to turn their entire stock. In contrast, a boutique store with bespoke manufacturing requests from customers may have limited raw materials and practice lean inventory to save money and improve customer satisfaction. Their goal may be to achieve an even higher inventory turnover ratio of perhaps 73 times per year or only 22 days to turn their entire stock.
Calculating your business's inventory turnover ratio can give you valuable insight into your operations' efficiency and effectiveness. By monitoring your stock valued against your goods sold, you can identify areas where you can reduce waste, streamline processes or invest in better supply chain management strategies. Knowing how long it takes for you to sell your products can help you make more informed decisions about how much stock to keep on hand and when to reorder supplies.
Find Out How to Determine Inventory Turnover Easily
Inventory turnover measures the number of times a company sells and replaces its inventory over a period. It is an important efficiency ratio that shows how quickly a business is able to sell its goods sold COGS and replace them with new stock. To determine the inventory turnover, simply divide the cost of goods sold by the average inventory value for that period. This will give you a clear picture of how well your business is managing its inventory and making sales.
Why is inventory turnover ratio important?
The inventory turnover ratio is a crucial measure used by businesses to analyze how quickly they sell their total inventory within a given period. The ratio tells you how many times a business sells its entire stock in a year, which helps you determine how efficiently the company manages its inventory. This metric is particularly relevant for businesses with vast average inventory levels or those that have high average inventory costs.
For small businesses or scaling manufacturers, an efficient inventory strategy can mean the difference between success and failure. A scaled-down version of the mass production model employed by large enterprises may not be enough to fully replenish stock waiting for bespoke features or expensive raw materials. As such, small businesses must ensure they don't have too much capital tied up in unsold items as this can lead to required costs that are difficult to recoup if sales are low.
In addition, a higher inventory turnover ratio indicates higher margins for the business. Companies with low sales but large inventory levels risk losing money if they cannot sell their stock before it becomes obsolete or outdated. The inventory turnover ratio lets you see this metric without relying on your naked eye and helps you make informed decisions about the business's future direction.
Inventory Management: How to Interpret Inventory Turnover Period
Inventory turnover period is a critical aspect of effective inventory management. It refers to the duration it takes for a company to turn over its entire inventory. The companys ratio is calculated by dividing the cost of goods sold by the average inventory value during a particular period. Comparing this ratio with industry peer group statistics can provide insights into practical diligence questions such as whether the companys inventory management is efficient or not.
Low turnover ratios suggest lackluster demand for finished goods, excess inventory, or ordering inadequate inventory. On the other hand, abnormally high turnover might mean that the company is managing inventory well and responding to pent-up demand. Fast-fashion retailers are highly regarded for their ability to research trends and move inventory quickly, resulting in high turnover rates that generate substantial revenue.
A positive sign of high turnover is that revenue generated from proceeds offset investment costs associated with recent purchases referenced historical customer demand patterns for specific products. In contrast, missing potential sales due to insufficient inventory can cause lost revenue for specific products or vice versa if there's an oversupply of items that don't meet sufficient customer demand. Therefore, companies must ensure that they price products at a competitive rate while monitoring consumer demand trends and managing their inventory appropriately.
How to improve inventory turnover with Katana’s inventory management software
Improving inventory turnover ratio is essential for businesses to minimize waste and increase profitability. With Katana's live inventory management software, businesses can easily manage their inventory across multiple locations and shop floor operations.
Katana lets you customize your specific workflow, making it easier to keep production flowing smoothly. By using lean manufacturing principles and monitoring your inventory levels in real-time, you can identify areas that need improvement and take action quickly.
With Katana's multiple sales channel support, you can easily track your sales on various marketplaces and adjust your inventory levels accordingly. This helps prevent overstocking or stockouts, which can negatively impact your inventory turnover efficiency. To experience the benefits of Katana's inventory management software for yourself, sign up for a free 14-day trial today!
Inventory Turnover Calculator – Excel Template
If you're looking to calculate your inventory turnover ratio, an Excel template can make the process much easier. By inputting your beginning and ending inventory values, along with your cost of goods sold, the template will automatically calculate your inventory turnover ratio for you. This modeling exercise can help you better understand how efficiently your business is managing its inventory and identify areas for improvement.
Inventory Turnover Ratio vs. Days Inventory Outstanding (DIO)
Inventory turnover ratio and Days Inventory Outstanding (DIO) are two metrics that companies use to measure their inventory management effectiveness. The inventory ratio measures how many times a company sells and replaces its inventory during a period, while the DIO metric calculates the average number of days it takes for a business to sell its inventory.
These metrics are closely tied because they both measure how fast a company is selling its inventory. The shorter the period it takes for a business to sell its inventory, the better. Companies strive to have a high inventory turnover ratio and a low DIO metric because it means that their products are in demand and they can quickly replenish their stock without having excess inventory sitting on shelves.
The DIO metric is useful for determining how long inventory sits before being sold. By knowing the average number of days needed to sell an item, companies can adjust their ordering processes accordingly. If products are taking too long to sell or have a high DIO metric, companies may need to re-evaluate their pricing strategy or marketing efforts to increase demand and reduce excess stock. In contrast, if products are moving too quickly or have a low DIO metric, companies may want to consider ordering more frequently or increasing production capabilities to keep up with demand.
What Is Inventory Turnover?
Inventory turnover is a financial ratio showing how many times a company turned over its inventory relative to its goods sold (COGS) during a period, typically within one fiscal year. The inventory turnover ratio is one of the efficiency ratios measuring how well businesses make use of their inventory, pricing, manufacturing, marketing, and other resources to generate revenue.
This metric indicates how quickly a business can sell its inventory and restock with new products. A high inventory turnover ratio means that the company can convert its merchandise into cash faster than its competitors or industry average. In contrast, a low inventory turnover ratio implies that the business may hold onto its stock for too long or struggle to move it without making discounts or write-offs. Therefore, monitoring and optimizing the inventory turnover ratio can help companies improve their profitability, cash flow management, and customer satisfaction.
Frequently Asked Questions
What is the formula for inventory turnover?
Inventory turnover formula is calculated by dividing the cost of goods sold by an average inventory. It measures how many times a company has sold and replaced its inventory during a certain period.
Is a higher inventory turnover better?
Yes, a higher inventory turnover is generally better as it indicates that a company is selling its products quickly and efficiently, freeing up cash flow for other business operations. However, it is important to balance inventory turnover with profit margins to ensure sustainable growth.
What is the formula for inventory ratio?
The inventory ratio formula is calculated by dividing the cost of goods sold by the average inventory for a given period. This ratio helps businesses determine how efficiently they are managing their inventory levels.
What causes increase in inventory turnover?
An increase in inventory turnover can be caused by several factors such as improved inventory management, faster sales cycles, increased demand for products, and a reduction in obsolete or slow-moving items.
How to optimize inventory turnover?
To optimize inventory turnover, you should regularly review your inventory levels, forecast demand accurately, implement efficient ordering and fulfillment processes, and identify slow-moving items to liquidate or promote.