Inventory turnover ratio - What is it and how to calculate?

Apr 05, 2024

A business inventory refers to all those products or items your company holds to further sell in the market. Now, some of the products sell fast off the shelf; some don’t even move when sold free with another item. Plus, if you sit down to analyze, various costs and charges are associated with maintaining an inventory. 

There are a few charges that can be avoided or terminated completely in order to bring about more efficiency. All these cost-cutting and profit-making scopes, particularly with inventory management, can be easily calculated using an inventory turnover ratio.

Despite knowing this, many businesses ignore this ratio. When these extra non-necessary costs are put together, the enterprise ends up losing a significant sum of money. 

So, what is inventory turnover ratio? How do you calculate it? What are the conclusions that can be drawn from the inventory turnover ratio?

What is inventory turnover ratio and how to calculate it?

Inventory turnover ratio is calculated by using the average inventory value as the denominator to divide the business’s Cost of Goods Sold (COGS). For a better understanding, let’s take an example,  

Your business is in the manufacturing industry and produces wine glasses. For the financial year 2021-22, the Cost of Goods Sold that is shown on the income statement is $5 million. The average inventory of your company is calculated to be $2.5 million. 

Inventory turnover ratio = $5 million/$2.5 million = 2 

This ratio indicates that your business was able to sell its complete inventory two times over the entire financial year. An extremely high inventory ratio can mean either of two things, excellent sales strategy and performance or inadequate inventory and inaccurate demand predictions.

What does inventory turnover ratio indicate?

Inventory turnover ratio helps a business to build an understanding of how to manage its inventory. Along with calculating the ratio, the necessary element is comparison to make meaningful decisions out of it.

Not all organizations would have the same ratio, so your competition is not with other industries. The real competition and influential decisions would come from comparing your inventory turnover ratio with your competitor’s. 

What does high inventory turn over ratio indicate?

So, if your business has a higher inventory turnover ratio, it means that your business is able to sell out all of its inventory. This also indicates a profitable sales and marketing operation and performance of the company. Along with this, the demand for your product is also high. 

When you see it from the cost perspective, higher ratios mean lesser investment in storage space and inventory ground management tasks and staff. But, here is the deal — if the ratio reaches too high according to your industry standards, it can be seen as a cautionary indication.

How? If your inventory gets sold out before the calculated day sales of inventory ratio (on average), you do not necessarily have an accurate sales forecast. This means your sales and purchases data needs to be analyzed more closely, and errors have to be resolved efficiently to reach an accurate number. 

What does lower inventory turn over ratio indicate?

On the flip side, a lower inventory turnover ratio suggests poor sales and marketing operations and impact, inaccurate demand forecasting, and, ultimately, poor inventory management. Additionally, you need to realize that unsold inventory means extra costs for storing and managing it. Also, your product might not be in demand and/or is obsolete. 

Immediate actions towards improving management and product upscaling must be taken in this scenario. Inventory is amongst the most significant assets of a business. Lacking coherent management can cause serious damages like extra investment, which could have been avoided. 

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What is a good inventory turnover ratio?

Obviously, every business wants to achieve a profitably high inventory turnover ratio according to its industry standards. While deciding upon a decent inventory turnover ratio number, along with the competitor's ratios, product type, and season of demand must also be considered. Different industries have different standards. Hence, the benchmarks also differ. 

Let's take examples of different business industries to comprehend the right ratio level.

For an industry of products with no-specific shelf life definitive, like clothes, there can be a possibility of an extremely high inventory turnover ratio. If a particular style is trending, stocks of that product would be sold out fast. The business decision-makers would have to keep a close eye on the demand records and data to keep the ratio to an acceptable optimum level. 

Another industry example can be food and beverages, which sell highly perishable goods. The ratio here is supposed to be the highest in comparison to any other. This is because these products have the trait of expiring. Once their shelf life is over, they become useless. Hence, efficient management of these products and the right assumptions of their demand are essential for the business. 

A low inventory turnover ratio might arise from holding too much stock or your product has quality issues and obsolescence qualities. When you sit to analyze this situation, it shows that your business is wastefully spending money on storing and managing that leftover stock, and its value of it also keeps depreciating over time.

How to improve the inventory turnover ratio?

1. Place orders or manufacture mindfully

Leftover inventory majorly arises from ordering more than required or manufacturing without determining the actual demand. No business wants to order or produce smaller quantities of products. This is because the shelves would be empty soon, and huge investments in restocking would be needed every now and then.

So, be smart, and evaluate the relevant data history to order mindfully, not too low, not too high. Especially when you launch or are trying to sell a new product, be conservative while creating a stock of it.

2. Invest in business marketing

If you are facing a low inventory turnover ratio, one of the most constructive and long-term solutions is investing in marketing and advertising. This brings your product into the limelight. The consumers would know that your product is available in the market.

Plus, the customers who are out of your direct reach would also get the information and might end up buying your product. Channels like email marketing and social media marketing can be used to aim at a larger group target audience specifically. 

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3. Identify product qualities and move them around

Everything comes down to smartly studying the market and demand. Then, placing the right product in front of the right target audience.

Understanding which is the product most in demand or is the one which can be an ‘impulse buy.’ Place that product at the spot where most customers would visit. 

For example, if your company sells handbags, and a specific kind of holographic bag is trending, place it as the first thing people would see on your e-commerce website. The chances of the customers buying that product increase — before navigating to any other option, you tacked the trending bag picture in their mind.

Try different placement styles and options. All this while studying the changes in your inventory turnover ratio. Stick to the option that keeps the ratio at the desired number.

4. Give discounts at the right time

Leftover unsold inventory is just occupying space, and no profitability is being generated. Hence, to get rid of it and to bring in products with higher demand, discount the previous ones. You can offer deals like buy-one-get-one or 50%-80% flat discounts.

Anything that is discounted tends to attract people’s attention. So, the products that weren’t leaving the shelf would now sell quicker. This will help create space and make more revenue.

Why is the inventory turnover ratio important?

The inventory turnover ratio is an efficiency measure that is primarily used to check how quickly your business is able to sell its inventory. Your business’s efficiency ratio can be compared to general industry standards for better performance understanding.

Again, the maximum and minimum limits of the ratio depend from business to business and industry to industry because the product qualities and market scope vary for all. 

However, a general inventory turnover ratio that is considered good, stands between 5 to 10. Inventory turnover ratio analysis helps inventors check if your company would be a good investment opportunity.

Is your business meeting industry standards? How often does your stock clear out? These questions are majorly answered through an inventory turnover ratio analysis. 

Measuring the liquidity capacity of a business is another major use of calculating the inventory turnover ratio. Liquidity is defined as the business trait that shows how much dispensable in-hand cash a business holds or is able to maintain.

A higher inventory turnover ratio means that the business has frequent incoming cash from customers and hence has a higher liquidity capacity. A higher inventory turnover ratio is an indicator of good business health and investment scope. 

Ultimately every metric and measure is made to help your business come up with better performance and profitability analysis. Using the metrics can not only help in knowing more deeply about the functioning and results of those business tasks, but it also helps in making more informed and data-backed decisions.

These decisions can be related to making amends in procedures, adopting automation wherever needed and possible, investing smartly in resources, and appropriate resource allocation. Just be mindful and make smart use of the metrics available.

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What factors affect the inventory turnover ratio?

The two major things used to calculate the inventory turnover ratio are the Cost of Goods Sold and average inventory. Hence, all the factors that affect these two elements have the potential to affect the inventory turnover ratio as well.

What happens if the inventory turnover ratio increases?

An increased level of inventory turnover ratio would mean faster selling products, increasing operating profit, and enhancement in the overall business revenue.

Is it better to have more or less inventory turnover?

Check against your business’s industry standards. The generally accepted standard of the inventory turnover ratio is 5 to 10.