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Inventory Turnover Ratio – Formula, Examples and Tips

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Inventory Turnover Ratio
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Inventory is a crucial part of any business. It is directly linked to the profit of the company. In a business, it is common that sometimes the product sells off soon and sometimes the product remains on the shelf for a long time. All companies should have accurate data about their products. It means that the companies must know what’s coming and what’s moving. This is where inventory turnover calculation is beneficial. It gives information on everything about the inventory and its products. From pricing strategy and supplier relationships to promotions and product lifecycle, get relevant data with this strategy.

Further, the inventory turnover ratio provides information on a company’s forecasting, inventory management, sales and marketing expertise. Overall, the turnover ratio is required to identify and keep the sales sail in the right direction.

What is Inventory Turnover Ratio?

The inventory turnover ratio is also known as the stock turnover ratio. It refers to the total duration of the product stored in the inventory till it is sold. Inventory turnover is a financial metric that indicates how frequently a company replenishes its inventory in relation to the expenses incurred for producing those goods in a specific timeframe. If the company sells all of the stock it purchased, it means that one complete turnover of inventory is over.

Many high-achieving companies have multiple inventory turnovers every year. It mainly depends on the industry type and the product category. Luxury items sell very slowly and will sell only a few units. Conversely, consumer packaged goods sell faster and have a high turnover.

The turnover ratio is determined through a mathematical computation, obtained by dividing the cost of goods sold by the average inventory over the corresponding period. A higher ratio is generally more favourable than a lower one, as it typically signifies robust sales performance. The factors affecting inventory turnover include supply chain challenges, over stocking and changing customer expectations.

Also Read : What is Inventory Cost? – Types and Examples

Understanding Inventory Turnover Ratio

If a company regularly calculates and tracks inventory, many problems regarding the inventory will be solved. It will assist companies in making smart decisions in areas such as pricing, manufacturing, marketing, purchasing and warehouse management. The main purpose of the inventory turnover ratio is to measure the number of sales a company generates from its stock.

There are various Key Performance Indicators (KPIs) that offer valuable insights on enhancing sales or increasing the market appeal of specific stock or the overall composition of inventory.

Inventory Turnover Ratio Formula

The formula for computing the inventory turnover ratio is as follows –

Inventory turnover ratio = Cost of goods Sold/ Average Inventory

Here, the Cost of Goods sold is the total budget assigned for the production of goods till it is sold by the company in a specific period. The cost of goods sold is recorded in the Income statement.

Average inventory represents the mean value of inventory calculated over a specific period. Usually, an analyst will prefer using the average inventory value or end-of-period value of the inventory.

For example, let us consider seasonal sales where specific goods are sold in large numbers and the goods are depleted from the inventory by the end of the season. Nonetheless, the turnover ratio can also be computed by using the ending inventory figures for the same period in which the cost of goods sold (COGS) number is recorded.

How does Inventory Turnover Ratio work?

If there are highs and lows from outlier changes given in a particular period such as a day or a month, the average inventory is used. Hence, the average inventory can be relied upon. If you want to calculate the amount of time to sell all the inventory in hand currently, the following formula can be used. This formula can be calculated for Days sales of inventory(DSI)

(Average Inventory/ Cost of goods sold) * 365

How to Calculate Inventory Turnover Ratio?

The inventory turnover ratio can be calculated by using a standard method which includes market sales information or cost of goods sold divided by the inventory. The calculations begin by calculating the average inventory for a specific period. Hence, the average inventory is divided by the sum of the beginning and ending inventory divided by two.

Average Inventory = (beginning inventory + ending inventory)/ 2

If your business doesn’t have any seasonal fluctuations, you can utilize ending stock instead of average inventory. Having more data points is beneficial. Therefore, divide the monthly inventory by 12 to obtain the annual average inventory. Subsequently, apply the inventory turnover formula.

Inventory Turnover Ratio = Cost of Goods sold/ Average Inventory

Example of Inventory Turnover Ratio

Let us better understand the inventory turnover ratio with a simple example. If a business had an annual cost of goods sold (COGS) of Rs 1,000,000 and the average inventory for the same period was Rs 200,000, the inventory turnover ratio would be 5 (1,000,000 ÷ 200,000). This implies that the company turns over its inventory five times within the year. A higher ratio generally indicates more efficient inventory management, suggesting potential for increased sales and profitability. It’s a crucial metric for evaluating a company’s operational effectiveness and financial health.

What can Inventory Turnover Ratio tell you?

We have learned earlier about the inventory turnover ratio in detail. Inventory turnover measures the frequency with which a company replenishes its inventory in relation to its cost of sales. If there is a higher inventory turnover ratio, it is better.

If the company has a low inventory turnover ratio, it indicates that the sales are weak or caused due to excess inventory which is also known as overstocking. In addition, low inventory turnover points out the company’s weak marketing strategy or poor marketing.

If the company has a high inventory turnover means that the sales are going strong. It also indicates the business has inadequate inventory. Here, the company should balance out the inventory requirements and keep the right amount of inventory to fulfil all the sales needs.

Here an important point to note is that a low inventory turnover ratio can benefit the business during inflation or supply chain disruption.

Inventory turnover is the speed at which a business can turn its inventory into sales. This will indicate a better business performance and will have a high inventory turnover ratio. If an item remains in the inventory for a long time, the company will incur holding costs and it indicates that the customers won’t come back for this particular product.

For example, popular fast fashion brands normally limit runs and soon as the demand diminishes, they replace the inventory with new ones. If the items are slow-selling, then the business has to pay high holding costs. Additionally, low inventory turnover carries the opportunity cost of delayed stocking of potentially more popular merchandise, as items that take longer to sell hinder the introduction of new inventory.

You may also like to read : What are Inventory valuation methods and their importance?

What is a Good Inventory Turnover Ratio?

Inventory turnover ratios indicate the number of times the company replenish the inventory in a specific period. A high inventory turnover rate is always expected.

⇒High Inventory Turnover Ratio

It represents strong sales and high market demand for the product. The inventory gets replenished more and gives a high turnover.

⇒Low Inventory Turnover Ratio

It indicates overstocking of a company’s inventory or poor demand for the product. It causes over stocking and the business will have to incur the holding cost. If the company’s inventory remains unsold, there may come a point where it needs to be adjusted down on the balance sheet to reflect its true, lower value.

Final Takeaway

To summarize, replenishing an inventory is a crucial task for the business. Inventory turnover ratio is a financial calculation used by the business to know how many times a company replenishes an inventory on hand in a specific period. The ratio is very useful for making critical decisions regarding pricing, manufacturing, marketing and purchasing.

ERP software is an advanced solution to accurately calculate inventory turnover ratio to assess the performance of the business. Implement this best business management solution today for efficiency.

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