Inventory Turnover Ratio: Definition, Formula, Working, And More
If the inventory turnover ratio of your business is high, it means that your business is able to manage its stock in an effective manner. The measurement gives you an idea of how many times the inventory of your business is sold or used in a given period of time. If you compare the cost of sold goods of your company against your business’s average inventory, you will get the inventory turnover ratio of your business.
In this article, you will learn what inventory turnover ratio means in business and how it works. Apart from that, we will also discuss the formula of inventory turnover ratio so that you are able to measure your business’s inventory. Additionally, you will also learn about what is a good inventory turnover ratio for a business. Finally, we will share with you a simple example by calculating the inventory turnover ratio.
What Is Inventory Turnover Ratio? – Definition
According to Investopedia,
“Inventory turnover is a financial ratio showing how many times a company turned over its inventory relative to its cost of goods sold (COGS) in a given period. A company can then divide the days in the period, typically a fiscal year, by the inventory turnover ratio to calculate how many days it takes, on average, to sell its inventory.”
With the help of the inventory turnover ratio, you will be able to make better business decisions related to various factors in the business. Some of these factors include pricing, marketing, manufacturing, and purchasing. Calculating this ratio will allow you to measure how well your business is making use of its assets.
Read More: What Is Continuity In Business, And Why Is It Important?
How Does Inventory Turnover Work?
The inventory turnover ratio of your business will help you evaluate how efficiently your business has been using its inventory within a time period against the cost of goods sold in the same period of time. This will give you a clear picture of how the business is making use of its inventory. This further helps in making informed decisions in the future and helps in assessing factors like pricing, production, and manufacturing.
Two factors help in determining the inventory turnover ratio –
Cost of Goods Sold (COGS):
This is the cost associated with the production of the business or the purchasing of the products that the business later sells to the customers.
Average Inventory:
This is the average of the costs of the inventory that the business pays over multiple time periods.
Basically, the inventory turnover ratio helps the business to improve its inventory management process. If the inventory turnover ratio is high, then it indicates that the business has strong sales or the inventory is not up to the mark. On the other hand, a low inventory turnover ratio indicates that the business is stocking too much inventory and is not selling enough.
According to the Forbes Advisor,
“Knowing how often you need to replenish inventory, you can plan orders or manufacturing lead times accordingly. When inventory isn’t moving quickly, the business must analyze why. Possible reasons could be that you have a product that people don’t want. You may not be doing enough marketing for that product. Or, you can simply buy too much stock that is well beyond the demand for the product.”
What Is The Formula For Inventory Turnover Ratio?
You can calculate the inventory turnover ratio by dividing the cost of goods sold in a particular time period by the average inventory cost in the same time period. Here is the formula for the inventory turnover ratio:
| Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory |
What Is A Good Inventory Turnover Ratio?
According to Nerdwallet.com,
“The higher your inventory turnover ratio, the better — within reason. […] If your inventory turnover is low, your stock might be spending too much time sitting on your shelves, not being sold. That translates into money being wasted on inefficiently used storage space, plus the possibility that the longer the inventory sits around, the more likely it’ll get damaged or depreciate in value.”
In general, the higher the inventory turnover ratio, the better it is for businesses. However, if you are the owner of a small business, you must consider the types of products you deal with, as well as the inventory turnover range that is common for your industry.
For example, businesses that deal with perishable goods, like groceries, bakeries, and related businesses, mostly have a very high inventory turnover ratio. This is because of the fact that the products of these businesses expire soon and lose value much faster. On the other hand, businesses that deal with non-perishable goods like shoes generally do not have a high inventory turnover.
Explaining Inventory Turnover Ratio With An Example
Let’s find the inventory turnover ratio of a company named XYZ.
As per the income statement of XYZ, the cost of goods sold amounted to $2 million.
The cost of inventory of XYZ for the start of the year was $250,000, and at the end of the year, the inventory amounted to $750,000.
Therefore, the average inventory price of XYZ = ($250,000 + $750,000)/ 2 = $500,000.
Now, since Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Therefore, the Inventory Turnover Ratio for XYZ = $2 million / $500,000 = 3.
This means that the business sold its inventory three times over throughout the entire fiscal year. Hence, it takes an average of 122 days (365/3) to fully sell out its inventory.
Read More: Business Continuity Plan – What Is It, And How Does It Work?
Final Thoughts
Calculating the inventory turnover ratio of the business will allow you to get a good idea of how efficiently the business is managing its assets. You can calculate the inventory turnover ratio for your business by finding out the cost of goods sold and dividing it by the average value of the inventory within a given period.
A higher inventory turnover ratio shows that the business has strong sales. However, in some cases, it also indicates that the inventory stocking of the business is inadequate. Do you have any recommendations regarding how to manage inventory better? Share your ideas with us in the comments section below.
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