Inventory Management Software

Everything you need to Know about Inventory Turnover Ratio

Everything you need to Know about Inventory Turnover Ratio

Inventory turnover ratio is a measure of your ability to liquidate the inventory in a given timeframe.  It's a ratio between sales made and the inventory stocked. By managing the inventory turnover ratio, companies can manage the most important financial asset and the consistent source of revenue for their company-Inventory. The most common interpretation of the inventory turnover ratio is: 

  • A higher inventory turnover ratio indicates that your business can sell goods easily and frequently. 
  • A lower inventory turnover ratio indicates that your business takes time to sell products, and you don't need a frequent refill of inventory. 

However, multiple factors and industry-specific variables play a significant role in deciding how the inventory turnover ratio should be interpreted. Various industries and different business types have different inventory turnover ratios. This article will provide you with all the information you need to know about the Inventory turnover ratio.

What is Inventory Turnover Ratio?

Inventory turnover ratio is the ratio between sales made in a given period, and the average inventory held during the same period. The ratio measures the number of times a business sold its entire inventory. It is also known as the stock turnover ratio. 

Why is it critical to improve the inventory turnover ratio?

A lower inventory ratio means that a significant amount of the company's capital is tied up in its inventory. Though inventory is actually a type of asset lying with the company, it can be monetized, only if inventory sells and fetches cash. It is the reason why companies don't consider inventory as a cash equivalent when they calculate 'Quick Ratio' to gauge their liquidity position. (Quick ratio is another ratio that is frequently used to compare a company's economic strength). 

Inventory is also a risk for the company until it is sold. It is a risk as no business can guarantee that it will be able to sell its entire inventory in all types of market conditions. Moreover, holding costs, interest rates on loan taken for raw materials to produce goods, and employee costs to take care of the inventory can drain the capital of business if inventory remains unsold. It is, therefore, essential to improve the inventory turnover ratio to avoid blockages of funds. A higher inventory ratio suggests a more profitable and more efficient firm. Companies, therefore, make all efforts to keep their inventory ratio aligned with the industry standards. 

Formula for inventory turnover ratio 

Formula for inventory turnover ratio

For example, at the beginning of the year 2019, Company A had an inventory worth $30,000. They purchased more inventory valued at $115000 in the same year. At the end of the year, their inventory was worth $20,000. 

How to Calculate the inventory turnover ratio?

According to the formula, we will first calculate the costs of goods sold and then the average inventory for the year 2019. 

Average inventory is taken as it is a more accurate measure of determining the inventory turnover ratio. Businesses may have ups and downs in their sales throughout the year,  seasonal trends, and sudden unexpected high or low sales. Therefore, it is justifiable to calculate the inventory turnover ratio with average inventory to visualize a complete picture of the overall inventory trend. 

CoGS= Beginning inventory+Net Inventory Purchases-Ending Inventory

=30000+115000-20000

=125000

Average inventory=(Beginning Inventory+Ending Inventory) ÷ 2

=(30000+20000) ÷ 2

=50000÷ 2

=25000

Now, we know the cost of goods sold was $125000, and the average inventory was $25000 for the year 2019. Now to calculate inventory turnover ratio for the year 2019, we will apply the formula; 

Inventory turnover ratio= COGS ÷ Average Inventory

125000÷ 25000=5

Company A's inventory turnover ratio was 5 for the year 2019.

This means that company A was able to sell its inventory five times in the year 2019. It means in 365 days; company A replaced its stocks five times, which translates to 365/3=73 inventory days. 

It takes an average of 73 days for company A to sell its products. 

Now, what is the use of this number? Inventory turnover ratio is one of the most studied and valued metrics by businesses. Let us try to understand why does the inventory ratio matter?

Importance of inventory turnover ratio

importance of inventory turnover ratio

The inventory turnover ratio is an important number as:

  • It keeps your supply chain healthy by telling you exactly when you should refill your warehouses.
  • It saves you from unnecessary inventory storage costs.
  • If you have an inventory turnover ratio below industry averages, you can quickly diagnose issues such as your sales getting weak, products getting obsolete or outdated, quality issues in products, lower return on investment on some products, etc. 
  • If you have an inventory turnover ratio above the industry averages, you can ramp up your inventory, make more supplier contacts, can choose to increase prices for the best selling products, etc. You can also choose to supply products only on pre-orders. 
  • You know that before products get expired or outdated, you have to put them up for sale on discounts. 
  • Inventory turnover ratio is a key performance indicator (KPI) that banks check for providing loans with inventory as a collateral. Banks know that if you can sell inventory easily, you would be able to pay back the loan on time. Managing this ratio can help you in stressed times to procure some capital. 
  • It can be used for peer comparison and your business's performance against the broader industrial market. Let us see how: 

Using Inventory Turnover Ratio For Competitor Analysis

Comparing your inventory turnover ratio with your industry's averages is the best way to see how your business is performing. For example, the average inventory turnover ratio for the Automotive sector (Car dealers) is in the range of 2-3, but in the same sector for automotive component makers, it can be as high as 40. For FMCG, it is around 8-12. 

Therefore, a higher or lower inventory turnover ratio can be best interpreted for your business when you gauge it with respect to your industry's averages. Cross-industry ratios should never be compared, as you won't get the true measure for your business with such comparison. Let us see the below example for more clarity: 

Company 1

At the beginning of the year 2020, Company A had an inventory of $15,000.  At the end of the year, their inventory was $5,000. The company reported that they sold goods for $40,000.

The average inventory for 2020 is= 15,000 + 5,000 / 2 = 10000

Cost of Goods Sold = 40,000.

Inventory Turnover Ratio = 40,000/10000 = 4

Company A’s inventory turnover ratio is 4. 

Company 2

At the beginning of the year 2020, Company B had an inventory of $25,000.  At the end of the year, their inventory was $15,000. The company reported that it sold goods for $120,000.

The average inventory for 2020 is= 25,000 + 15,000 / 2 = 20000

Cost of Goods Sold = 40,000.

Inventory Turnover Ratio = 120,000/20000 = 6

Company A’s inventory turnover ratio is 6. 

Analysis:

The company A clears its inventory 4 times in the year 2020, while the company B clears the same six times. Now, what do these two numbers tell us about the inventory management skills of the company?

conclusion

Inventory turnover ratio miscellaneous cases

In the above case, we knew the exact figure about the cost of goods sold and average inventory, so it was easy for us to come to the above conclusion. But remember, the Inventory turnover ratio cannot always give you a complete picture in isolation. There are various terms and conditions attached to this seemingly easy assumption. A higher inventory turnover ratio does not always mean high profitability. 

To make things clear, let us assume that we know only the ‘inventory turnover ratio’ of two companies X and Y. Company X has an inventory turnover ratio of 5, and Y has the same as 8. We have no idea about their COGS or average inventory, or what products do they sell? 

competitor analysis with inventory ratio

Therefore, for products with the same size, quality, similar pricing, same industry, and similar geographic and business environment, inventory turnover ratio is a great measure of competitor analysis and of knowing the efficiency of the companies in handling their inventory. A Lower inventory turnover ratio for any company in such a case would mean low sales, overstocking, and poor liquidity conditions for its inventory. 

Various ways to apply inventory turnover ratio

Various methods for inventory turnover ratio

There are multiple ways to apply the inventory turnover ratio to see how your businesses deal with inventory. These ways provide you with necessary insights and give you a 360-degree angle to visualize the inventory needs. Let us analyze them in detail:

  1. Inventory turnover ratio on total inventory

The most common way of applying inventory turnover ratio is to apply it on total inventory that you have across all business locations. For example, Amazon's inventory turnover ratio was 8.82 for the Year 2019. (source-CSI market). It means Amazon was able to replace its inventory 8.82 times in a year. Now, when we are talking about Amazon's inventory ratio, we calculated the ratio of total inventory that Amazon sells across the globe in a year. 

This figure provides us a complete picture of all products that Amazon is able to sell in a fiscal year. But this figure won't tell us about the highest or lowest selling product categories or seasonal trends or about the festive sales. If Amazon wants to get rid of some of the slow-selling inventory, then it has to dig deeper into the inventory turnover ratios for different product categories. 

  1. Inventory Turnover by Product or Category

Another popular way of calculating inventory is to calculate it product-wise. Again taking the example of Amazon, there are certain products that this ecommerce giant is able to sell faster than others. For example, in the electronics category, Amazon's best-selling products are fire TV stick, Echo dot, in Sports category loop bands, and due to the COVID 19 situation, the best selling product in Skincare is now the face mask. 

Knowing the best sellers and the laggards on your shelves make you know what products you should stock more. It makes sense as Amazon or any other retailers, or ecommerce business cannot simply keep products based on the cumulative inventory turnover ratio. 

  1. Inventory Turnover Ratio by Seasonal trends

Products such as umbrellas, school bags, surfing boards, summer wear, winter wears, ACs, etc. are seasonal products. While knowing the total inventory turnover ratio can give you a complete picture of your overall business, it is not sufficient to deal with the seasonal ups and downs. Therefore, calculating the inventory turnover ratio for seasonal months is another way of applying inventory ratio.    

  1. Inventory Turnover Ratio on an Annual basis

As we discussed above, Amazon's annual inventory turnover ratio was 8.82.  It is the average of all four quarters of a fiscal year. It is a significant ratio as even if the business was down during a quarter, maybe the next quarters pulled it up. Thus, the annual ratio covers up the complete trend for your inventory in a given year. 

  1. Inventory Turnover Ratio on Quarterly  basis

Inventory turnover ratio is generally calculated on an annual basis, but it can also be calculated with different timeframes as per your business needs. A popular practice of companies is to calculate inventory turnover ratio on a quarterly basis. At the end of the fiscal year, businesses add it to get the yearly average.  For example, Amazon's quarterly inventory ratio for the first quarter of 2020 was 9.17. 

However, in this article, for the sake of clarity, when we mention 'inventory turnover ratio,' readers should know that unless specified otherwise, we are referring to the annual timeframe. 

Sectors and Industries that have the highest inventory ratios

Highest inventory ratio sector wise

Apart from the above-mentioned sectors with the highest inventory turnover ratio, other prominent sectors such as retail, healthcare, energy, and capital goods have a ratio below 10. Retail Sector had a ratio of 9.1 for the year 2019. 

Cash Flow and Inventory Turnover Ratio

Cash flow for any company is dependent on its ability to sell its inventory. What you purchase or produce by procuring raw materials has to be sold to bring cash profits. Without profits and cash flow, businesses won't be able to decide and manage other business expenses such as warehouse rent, labor costs, utility charges, etc. Inventory turnover ratio is an important metric for balanced growth for businesses.  

How inventory turnover ratio and demand are proportional to each other?

Businesses can anticipate demand in various time frames using the historical inventory turnover data. Demand-driven businesses can also analyze the seasonality and consumer trends that influenced the inventory turnover ratio in the past to forecast demand. A very interesting aspect of the inventory turnover ratio is that a higher inventory ratio means increased demand for products, and inversely a higher demand can increase the inventory turnover ratio. So, if businesses want to improve their inventory turnover ratio, they can do so by increasing demand artificially. Let us see how:

How to increase the demand to improve inventory turnover ratio?

Limited period promotions and discounts are the best way to sell the slow-selling overstock inventory. Steep discounts for limited periods can boost the sense of urgency in consumers. This marketing strategy should be considered for inventory lying idle for a long time, thereby causing unnecessary expenses for storage. It can also help to sell the inventory that is about to get expired in a couple of months. 

Inventory rate of return

inventory rate of return

How Inventory Turnover Ratio Works for managing business space?

Today owning a business space has become very costly. For instance, according to Statista, the annual rent of Hongkong's Causeway Bay retail space is $2745 per annum per square foot, Upper 5th Avenue in New York is $2250, and New bond Street in London will cost businesses $1714  per square foot per year. Ensuring high inventory ratio and maximum financial returns on space owned or rented are crucial for success in the businesses. 

Inventory turnover ratio can highlight the consistency of sales or dynamic spurts in product sales. By analyzing changes in inventory turnover ratio, retailers, manufacturers, ecommerce business owners, etc. can understand what is driving their sales upward and downward. They can get rid of poorly performing inventory to optimize warehouse or showroom space.

What is the optimal inventory turnover ratio for my business?

Finding the optimal inventory turnover ratio or the perfect inventory turnover ratio for a business can be very tricky. There is no one-size-fits-all when it comes to inventory ratio. But businesses can follow a thumb rule that the optimal inventory level for their business is the one that covers all their sales without any inventory shortage or surplus. It can be achieved through synchronized purchase and sales of the inventory. 

inventory ratio of prominent sectors

Inventory turnover ratio and inventory management system

Inventory management system minimizes the wastage of time, efforts, and processes to increase your efficiency to handle your inventory. With automated processes, it perceives demand and standardizes processes to optimize and manage inventory levels. See the below infographic to understand how inventory management systems can help to optimize inventory turnover ratio.

inventory-management-system-inventory-turnover-ratio

Conclusion

Inventory turnover ratio plays a crucial role in maintaining a healthy supply chain, organized warehouses, robust sales, and stock resource optimization. Inventory turnover ratio can answer many questions that you have about your inventory. Such as,

  • How well do you handle your inventory?
  • How fast can you sell what you buy?
  • Is your purchasing and selling in tune with each other?
  • Is your inventory overstocked or understocked? 
  • Is your purchasing level too low for your inventory to be sold quickly, and you are out of the stock too soon?
  • What is the optimum inventory level for your business?

With the integration of technologies such as inventory management software, warehouse automation, artificial intelligence, and machine learning, you can manage your inventory processes like never before to achieve the desired inventory turnover ratio.

James Mordy
James Mordy

James Mordy is a content writer for Goodfirms. A voracious reader, an avid researcher, a logophile, and a tech geek he loves to read about the latest technologies that are shaping the world. He often articulates the very nuances of the tech world in his blogs. In his free time, he loves to watch movies and analyze stock markets around the world.

Leave comment
Your email address will not be published. Required fields are marked *
Everything You Need To Know About Dropshipping
Inventory Management Software
Everything You Need To Know About Dropshipping

What Is Dropshipping And How Does It Work? How Is Dropshipping Different From Traditional Order Fulfillment and Affiliate Marketing? Why Is Dropshipping a Preferred M ... Read more

How to Handle Product Ecommerce Returns Efficiently?
Inventory Management Software
How to Handle Product Ecommerce Returns ...

What is E-commerce Returns Management? E-commerce Returns Management is a process followed by the members of the supp ... Read more

8 Best Free and Open Source Inventory Management Software Systems
Inventory Management Software
8 Best Free and Open Source Inventory Ma ...

Inventory is a key value for any company. Both excessive and surplus inventory can cripple an organization's financi ... Read more

GoodFirms