Strategy, Legal & Operations

A guide to inventory turnover ratio

Every business owner knows the importance of tracking inventory. But did you know there’s a key metric that translates stock flow into financial data? Learn all about the inventory turnover ratio and how it can help you optimize your business.

Your monthly inventory tracking lets you see whether sales are humming along or stumbling.

However, for a more precise evaluation of stock flow, and how it affects your bottom line, you can use the inventory turnover ratio to measure the efficiency of stock management in your business, in monetary terms. 

A solid understanding of the inventory turnover ratio can reveal how effectively you’re converting inventory into sales, impacting your cash flow, storage costs, and ultimately, your profitability. 

This comprehensive guide will walk you through the essentials of the inventory turnover ratio, including how to calculate it, interpret the results, and implement strategies to optimize inventory management.

How to calculate inventory turnover ratio

The formula for the inventory turnover ratio is simply COGS/average inventory. 

So, the basic steps for calculating the inventory turnover ratio are:

• Determine COGS: sum the cost of all goods sold during the period
• Calculate average inventory: add the beginning and ending inventory values then divide by two
• Apply the formula: divide COGS by average inventory

Here’s a quick example:

COGS: $500,000

Beginning inventory: $100,000

Ending inventory: $150,000

Average inventory: ($100,000 + $150,000) / 2 = $125,000

Inventory turnover ratio = $500,000/$125,000 = 4 times

This means the average investment in inventory was sold and replenished (turned over) four times during the period.

What is inventory turnover?

Inventory turnover is a measure of how frequently a company completes the cycle of selling and replacing its stock of goods over a certain period.

For example, if you sell your entire inventory 35 times during a 52-week period, your inventory turnover for the year is 35.

A lower inventory turnover of, say, 16 in one year means you’re selling much less stock in the same period. Inventory turnover therefore indicates how efficient your business is in managing its inventory.

High inventory turnover rates typically mean strong sales, whereas low turnover rates can indicate overstocking or inefficiencies in the sales process.

Keeping an eye on your monthly turnover and your annual turnover helps you identify trends in your business.

For example, monthly monitoring will enable you to see short-term trends, seasonal variations, and any unexpected issues.

This helps you make urgent adjustments before stock discrepancies get out of hand.

Annual monitoring of inventory turnover is a great way to evaluate long-term performance.

It lets you assess the effectiveness of your inventory management strategies and make informed decisions while planning for the future.

Together, monthly and annual monitoring of inventory turnover provide a comprehensive picture of your inventory efficiency and overall business health.

Inventory management software is a fantastic tool for effectively monitoring your inventory turnover on a monthly and annual basis, allowing you to quickly judge how well your stock is moving.

Comprehensive inventory management features that can automate tracking and provide real-time insights into your inventory turnover can help you maintain accurate records, forecast demand, and set optimal reorder points.

What is inventory turnover ratio?

The inventory turnover ratio provides a financial measure of inventory management efficiency, reflecting how effectively a company converts its inventory investment—cost of goods sold (COGS)—into sales. 

This ratio indicates how many times the value of the average inventory is sold and replaced during the period.

The number is written with the word ‘times’ to make it clear the ratio represents a frequency.

In addition to monitoring the inventory turnover ratio for the short- and long-term, it’s important to compare the ratio to industry benchmarks. 

What does the inventory turnover ratio tell you?

While inventory turnover provides a general understanding of how quickly you’ve sold and replaced your stock, the inventory turnover ratio offers a more quantifiable measure of efficiency.

This allows for more precise comparisons over time and with industry benchmarks. 

• A high ratio indicates efficient inventory management in terms of both value and volume. Combine with other profitability metrics, such as gross profit margin, to provide a more comprehensive view of a company’s financial health. 
• Generally, cash flow is improved when inventory turnover is higher because cash is coming into the business at a higher rate while inventory is being sold.
• If inventory turnover is low, storage costs will increase because you need to find storage for the inventory that hasn’t sold.
• The longer it takes inventory to sell, the greater the risk that it will become obsolete and never sell. And finally, efficient inventory management ensures products are available when customers need them, improving service levels and customer satisfaction.

What is a good inventory turnover ratio?

The ideal inventory turnover ratio depends on various factors, including industry norms, business models, and product types.

Try to strike a balance between keeping a high inventory turnover ratio without suffering anomalies like stockouts.

Generally, a balanced turnover ratio, as determined by comparing your case to industry benchmarks and company historical data, indicates good inventory management without overstocking or frequent stockouts.

Overstocking can lead to excess carrying costs, such as storage fees, insurance, and potential obsolescence.

On the other hand, frequent stockouts can result in lost sales, customer dissatisfaction, and damage to brand reputation.

Industries with fast-moving consumer goods, such as groceries or electronics, typically have higher turnover ratios compared to industries with specialized or customized products that require longer lead times (such as jewelry or automobiles).

Similarly, businesses with a just-in-time inventory strategy, where they hold minimal inventory and rely on frequent deliveries, tend to have higher turnover ratios than those with a more traditional warehousing approach.

Several factors influence the ideal inventory turnover ratio.

Industry characteristics

Different industries have different benchmarks for inventory turnover ratios based on their unique operating criteria.

Everything from supply chain and logistics setup to average transaction value can make a difference.

For example, industries with longer lead times for ordering and receiving inventory may naturally have lower turnover ratios.

On the other hand, industries with high-value items (like luxury cars) tend to have lower turnover norms compared to industries with low-value, frequently purchased items.

Business model

The business model of a company also impacts its ideal inventory turnover ratio.

E-commerce businesses, which often operate with limited physical storage space, tend to have higher turnover ratios than brick-and-mortar stores, which typically have large warehouses.

Product type

The type of product can also affect the ideal inventory turnover ratio.

Products with a short shelf life or that are subject to rapid technological advancements may require higher turnover ratios to minimize the risk of obsolescence.

Inventory turnover ratio in action

For a closer look at the effect of the turnover ratio, meet “Green Thumb Gardening Supplies”.

They sell gardening tools and equipment, and here’s their inventory turnover calculation for the year:

COGS: $400,000

Beginning inventory: $50,000

Ending inventory: $70,000

Average inventory: $120,000/2 = $60,000 

Inventory turnover ratio: $400,000/$60,000 = 6.67 times.

What does this mean for Green Thumb Gardening supplies? 

A great starting point is to take a look at the inventory turnover industry benchmark for gardening supply stores.

That comparison to the industry standard will tell Green Thumb whether they are performing as well as their peers in gardening supplies.

Another useful comparison is historical data.

If Green Thumb has been in business for several years, they can track inventory turnover results across each period.

For example, if their inventory turnover ratio was 9.5 in the previous year, and is now 6.67, they will want to investigate why the metric has dropped.

Possible explanations could include stocking new items customers weren’t interested in, decreased marketing efforts, or poor weather during peak gardening season.

What does a low inventory turnover ratio mean?

Remember, a higher turnover ratio points to better inventory efficiency, so it’s lower inventory turnover rates that should prompt management to investigate further.

Because the inventory turnover ratio considers COGS and average inventory during the period examined, it makes sense to take a look at sales and stock when considering reasons for a lower inventory turnover ratio.

Reasons for a low inventory turnover ratio could include:

Overstocking

Holding too much inventory that is not being sold quickly, leading to excess stock.

Poor sales performance

This could be due to a weak demand due to ineffective marketing, pricing issues, or poor quality products.

Inefficient inventory management

Lack of proper inventory control systems or poor product forecasting, resulting in excess inventory.

Seasonal products

Stocking seasonal items which don’t sell until the appropriate season arrives.

Obsolete inventory

Attempting to sell outdated products which no longer appeal to customers.

Supply chain issues

Delays in product delivery—due to congestion at ports, for example—can lead to lower inventory levels and potential stockouts.

Poor product mix

Stocking products that don’t align with current market demand or customer preferences.

Economic conditions

Economic downturns can reduce consumer spending, leading to slower inventory turnover.

High prices

Pricing products too high compared to competitors can lead to reduced sales and slower inventory turnover.

New product introduction

Introducing new products can sometimes result in older products not selling as quickly.

Only when you’ve identified the cause of low inventory turnover can you think about strategies to improve inventory management.

These could include enhanced marketing efforts, or research to better align product offerings with what customers want.

Is high inventory turnover good?

On the whole, yes. A high inventory turnover ratio is beneficial because it can reduce storage costs and the risk of inventory becoming obsolete.

It also indicates strong demand for your products, and that you have effective inventory management strategies in place.

Sometimes the only difference between two businesses in the same industry with different inventory turnover rates is the strength and success of their respective marketing campaigns.

Market competitiveness also allows businesses to adapt quickly to market changes, such as fluctuations in demand.

However, excessively high turnover can lead to stockouts, missed sales opportunities, and frustrated customers.

The key is to find the sweet spot that maximizes efficiency without compromising customer satisfaction

How to increase inventory turnover

So, assuming you don’t get carried away, and there is obvious benefit to increasing your inventory turnover, what strategies can you employ?

It probably requires a multi-faceted approach, so here are several ideas:

• Keep limited inventory or use a model such as just in time inventory management.

• Maintain strong supplier relationships so you can restock frequently with shorter lead times.

• Improve your sales and marketing efforts. For example, look into targeted marketing campaigns to reach potential customers and increase product awareness.

• Analyze sales data and identify trends so you can better understand customer preferences and adjust inventory accordingly.

• Optimize inventory management processes by implementing efficient inventory tracking systems, using forecasting techniques to determine optimal stock levels, and working with suppliers to reduce lead times.

• Perform regular inventory audits to identify slow-moving or obsolete items that can be cleared out to free up cash and storage space. 

Final thoughts

Implementing robust inventory management practices, leveraging technology, and staying agile in response to market trends will help you maintain an optimal inventory turnover ratio, ultimately supporting your business’s growth and stability.

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