In the world of business, nothing is more important than ensuring that the business and an investor's money are used efficiently. Each rupee tied up in stock not sold represents that much of your working capital that cannot be used for something else. Here is where the inventory turnover ratio provides a key metric to businesses in assessing the effectiveness of inventory management.
If you are a small business owner, aspiring business owner, or just happen to be a finance student, understanding this model of ratio is key. The inventory turnover ratio is a good way to see how well your company is doing and gives you a way to assess how many times your business sells and replaces all of its stock in a certain accounting period. Simply put, a measure of a company's health.
In this blog, we will cover everything you need to know about the inventory turnover ratio by outlining the simple two components of the formula, and then what an actual "good" inventory turnover ratio is, and present some helpful information to help you achieve a greater inventory turnover ratio.
How to Calculate Inventory Turnover Ratio?
Before we can discuss what a good ratio is, we must first clarify how you would calculate it. The calculation is fairly straightforward and takes two (2) components.
Let’s break down each part of this formula:
Cost of Goods Sold (COGS) - Representing the total cost directly associated with producing the goods sold by a company within a specific accounting period, including materials and labor. The value COGS indicated in your company's income statement would be used in the equation.
Average Inventory - This is the average value of your inventory for a period of time. It uses an average in order to factor in seasonal trends or other changes in inventory levels. To determine it, use the equation:
Average Inventory = Beginning Inventory + Ending Inventory/2
Practical Example:
Let's say a company's retail business had the following numbers for the last financial year:
Beginning Inventory: Rs. 1,00,000
Ending Inventory: Rs. 1,50,000
Cost of Goods Sold (COGS): Rs. 5,00,000
It is first necessary to determine the average inventory:
Average Inventory = Rs. 1,00,000 + Rs. 1,50,000/2 = Rs. 1,25,000
Now, calculate the inventory turnover ratio:
Inventory Turnover Ratio = Rs. 5,00,000 / Rs. 1,25,000 = 4
This means that the company sold and replaced the entire stock of inventory four times during the financial year.
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What is a Good Inventory Turnover Ratio?
This is the single most frequently asked inventory turnover question, and there's no one answer. Good inventory turnover ratios are not fixed values, as they can be very industry-dependent.
For example, a grocery store selling perishable products like milk and bread wants to turn this inventory very fast, as it could have an inventory turnover ratio of 50 or more. A car dealership selling durable, larger value products would have a ratio ranging from 4-8.
Here’s what different ratios can indicate:
High Inventory Turnover: comparison generally shows that a high turnover ratio is seen as a positive indicator. High turnover means that your customers are buying in full, and you have an effective process for managing your inventory, with the potential of having a low chance of excess, obsolete stock in your store. If this turnover is too high, it may be an indicator that the company isn't keeping enough inventory levels and, therefore, is missing the opportunity to sell product frequently or is leaving potential revenue on the table through stockouts.
Low Inventory Turnover: A low inventory turnover ratio could be a warning sign. It may indicate poor sales, excess stocking, or decreasing relevance of your products. This can hold capital, increase carrying costs (storage, insurance), and impact cash flow.
To understand what a good inventory turnover ratio is for your business, you'll want to look to industry benchmarks for inventory turns. You will typically find inventory turns from the financial statements of your competitors or investigate industry-specific data. If you need help analyzing the financial data, have a look at our article on "Fundamental Analysis in the Stock Market". To get professional insights and advance your skills in this area, consider enrolling in a Fundamental Analysis Certificate Course.
Factors That Influence Your Ratio
In addition to reviewing industry standards, there are several other elements that contribute to your overall inventory turnover ratio:
Product Type: As previously mentioned, product type matters: is it a perishable item, a seasonal item, and is it a high-end luxury item, as these categories of products will differ in nature and their associated turnover obligations.
Demand Forecasting: If you are able to accurately forecast customer demand, then you can better project stock levels with a view to improving the ratio. Consider measuring demand using past sales data or using experiential evidence of past product performances to intuit demand in the upcoming sales period.
Pricing Strategy: Pricing strategy is significant as price can accelerate or slow down your stock turnover, and an incorrect pricing strategy can lead to poor average inventory turnover ratios.
Economic Conditions: When economic conditions are poor, consumer spending may decline, which may reflect a lower turnover. A strong economy, however, can result in higher turnover.
Conclusion
The inventory turnover ratio is not simply a number; it is an efficient diagnostic tool for any business. If you know how to apply it, what is good or bad turnover is for your industry, and the forces that affect inventory turnover, you can make informed decisions to improve your management of inventory.
A good ratio indicates not only efficient activity, but also good sales and profit. By continually measuring and pursuing improvement of this metric, you will keep your business flexible, competitive, and ready for growth.
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