A guide to inventory turnover ratio

Have you been struggling to manage your inventory?

Wondering what you can do differently to improve the flow of stock through your business?

If you run a product-based business, understanding the inventory turnover ratio is key to managing your goods.

Efficient inventory management is a priority when it comes to inventory-based businesses.

Understanding and optimising your inventory turnover ratio can help you improve cash flow, reduce waste, and increase profitability.

This ultimate guide to inventory turnover will help you unlock the secrets to efficient inventory management.

Learn how to make inventory turnover work for your business!

What is inventory turnover?

Inventory turnover is a measure of how often a company sells and replaces its stock of goods over a certain period.

An inventory turnover of 35 during a 52-week period means your business is selling its entire inventory 35 times during the year.

A lower inventory turnover of 16 (during the same period) indicates a business is going through its stock only 16 times during the year.

Inventory turnover indicates the efficiency of a business in managing its inventory.

High inventory turnover rates typically mean strong sales, whereas low turnover rates can indicate overstocking or inefficiencies in the sales process.

Because inventory turnover can help you identify trends in your business, it’s a good idea to keep an eye on your monthly turnover and your annual turnover.

Monthly monitoring will enable you to see short-term trends, seasonal variations, and any unexpected issues.

Identifying trends, and especially surprising discrepancies, will allow you to make adjustments in a timely manner.

Annual monitoring of inventory turnover is a great way to evaluate long-term performance, assess the effectiveness of your inventory management strategies, and make informed decisions while planning for the future.

Together, monthly and annual monitoring of inventory turnover provide a more comprehensive picture of your inventory efficiency and overall business health.

To effectively monitor your inventory turnover on a monthly and annual basis, leveraging the right tools and inventory management software is crucial.

Comprehensive inventory management features that can automate tracking and provide real-time insights into your inventory turnover can help you maintain accurate records, forecast demand, and set optimal reorder points.

What is the inventory turnover ratio?

Inventory turnover ratio is a key metric used to evaluate how well a company is managing its inventory.

It is calculated by dividing the cost of goods sold (COGS) by the average inventory.

To determine the average inventory for the period, take the starting inventory, add the ending inventory, then divide by two.

This ratio helps businesses understand how quickly their inventory is being sold and replaced.

This ratio is typically presented as a value that indicates how many times the business’s inventory is sold and replaced during the period.

The number is written with the word ‘times’ to make it clear the ratio represents a frequency.

In addition to monitoring the inventory turnover ratio for the short- and long-term, it’s important to compare the ratio to industry benchmarks.

A benchmark is an industry standard that can be used to compare the performance of your business with that of your industry as a whole.

Benchmarks can be used to evaluate performance, identify areas for improvement, set realistic goals, and make informed decisions.

What does the inventory turnover ratio tell you?

The inventory turnover ratio helps businesses understand how quickly their inventory is being sold and replaced.

A high inventory turnover ratio indicates that a company is efficiently managing its inventory.

This means that the company is selling its inventory quickly and not holding on to it for too long. The opposite is true when a company has a low inventory turnover ratio.

Understanding inventory turnover is critical because how quickly a business goes through inventory impacts cash flow management, storage costs, inventory obsolescence, and customer satisfaction.

Generally, cash flow is improved when inventory turnover is higher because cash is coming into the business at a higher rate while inventory is being sold.

If inventory turnover is low, storage costs will increase because you need to find storage for the inventory that hasn’t sold.

The longer it takes inventory to sell, the greater the risk that it will become obsolete and never sell. And finally, efficient inventory management ensures products are available when customers need them, improving service levels and customer satisfaction.

How to calculate inventory turnover ratio

The formula for the inventory turnover ratio is COGS/average inventory. Calculating the inventory turnover ratio involves a few straightforward steps:

• Determine COGS: Sum the cost of all goods sold during the period
• Calculate average inventory: Add the beginning and ending inventory values then divide by two
• Apply the formula: Divide COGS by average inventory.

Here’s a quick example:

COGS: ZAR 500,000

Beginning Inventory: ZAR 100,000

Ending Inventory: ZAR 150,000

Average Inventory: (ZAR 100,000 + ZAR 150,000) / 2 = ZAR 125,000

Inventory turnover = ZAR 500,000/ZAR 125,000 = 4

This means the inventory turned over (was sold and replenished) four times during the period.

Inventory turnover ratio explained

To get a better idea of how inventory turnover works, let’s look at a real-life example.

Green Thumb Gardening Supplies sells gardening tools and equipment. Here’s their financial data for the year:

COGS: ZAR 400,000

Beginning Inventory: ZAR 50,000

Ending Inventory: ZAR 70,000

First we need to calculate their average inventory for the year.

This is done by adding ZAR 50,000 and ZAR 70,000 to get ZAR 120,000. Then divide by 2.

This works out to ZAR 60,000 average inventory for the year.

Now we can calculate the inventory turnover ratio by taking the COGS of ZAR 400,000 and dividing by the average inventory of ZAR 60,000.

This works out to 6.67 which means that Green Thumb Gardening Supplies turned over its inventory approximately 6.67 times during the year.

How inventory turnover ratio works

So, what does this mean for Green Thumb Gardening Supplies?

How do we know if this is good or bad or if they should investigate their inventory turnover ratio further?

Here’s where benchmark figures can help.

A great starting point for Green Thumb Gardening Supplies would be to take a look at the industry benchmark for inventory turnover for gardening supply stores.

Comparing their inventory turnover to the industry standard can help Green Thumb Gardening Supplies know if they are on track for their industry.

Another useful comparison is historical data.

If Green Thumb Gardening Supplies has been in business for several years, they can compare inventory turnover across the years they’ve been in business.

If, for example, inventory turnover was 9.5 in the previous year, Green Thumb Gardening Supplies would want to investigate why inventory turnover had dropped from the previous year.

Possible explanations could include stocking new items customers weren’t interested in, decreased marketing efforts, and a poor weather during peak gardening season.

What does a low inventory turnover ratio mean?

A lower inventory turnover should alert management to investigate further.

Because the inventory turnover ratio considers COGS and average inventory during the period examined, it makes sense to take a look at sales and stock when considering reasons for a lower inventory turnover ratio.

Reasons for a low inventory turnover ratio could include:

• Overstocking: Holding too much inventory that is not being sold quickly, leading to excess stock.

• Poor sales performance: This could be due to a weak demand for products due to ineffective marketing, pricing issues, or poor quality products.

• Inefficient inventory management: Lack of proper inventory control systems or poor product forecasting, resulting in excess inventory.

• Seasonal products: Stocking seasonal items which don’t sell until the appropriate season arrives.

• Obsolete inventory: Attempting to sell outdated products which no longer appeal to customers.

• Supply chain issues: Delays in product delivery can lead to excess inventory that doesn’t sell quickly.

• Poor product mix: This involves stocking products that don’t align with current market demand or customer preferences.

• Economic conditions: Economic downturns can reduce consumer spending, leading to slower inventory turnover.

• High prices: Pricing products too high compared to competitors can lead to reduced sales and slower inventory turnover.

• New product introduction: Introducing new products can sometimes result in older products not selling as quickly

Identifying causes of low inventory turnover involves not only determining the cause but also implementing strategies to improve inventory management, enhance marketing efforts, and better align product offerings with what customers want.

What does a high inventory turnover ratio mean?

A high inventory turnover can be beneficial for a company because it can reduce storage costs and the risk of inventory becoming obsolete.

Additionally, a high inventory turnover ratio can indicate that a company has a strong demand for its products.

Sometimes the only difference between two businesses in the same industry with different inventory turnover rates is the strength and success of the businesses’ marketing campaigns.

Businesses can achieve higher inventory turnover ratios by keeping limited inventory or using a model such as just in time inventory management.

Maintaining strong supplier relationships enables businesses to restock frequently with shorter lead times.

Market competitiveness also allows businesses to adapt quickly to market demands and changes.

A high inventory turnover ratio can indicate products are selling quickly, and the business has effective inventory management strategies in place.

Even when inventory turnover is high, though, businesses should keep an eye on their stock to avoid running out of products customers want and potentially creating an unfavorable customer service experience.

What is a good inventory turnover ratio?

The ideal inventory turnover ratio depends on various factors, including industry norms, business models, and product types.

Generally, a balanced turnover ratio, as determined by comparing to industry benchmarks and company historical data, indicates good inventory management without overstocking or frequent stockouts.

Overstocking can lead to excess carrying costs, such as storage fees, insurance, and potential obsolescence.

On the other hand, frequent stockouts can result in lost sales, customer dissatisfaction, and damage to brand reputation.

Industries with fast-moving consumer goods, such as groceries or electronics, typically have higher turnover ratios compared to industries with specialised or customised products that require longer lead times (such as jewelry or automobiles).

Similarly, businesses with a just-in-time inventory strategy, where they hold minimal inventory and rely on frequent deliveries, tend to have higher turnover ratios than those with a more traditional warehousing approach.

Several factors influence the ideal inventory turnover ratio.

These include:

Industry norms

Different industries have established benchmarks for inventory turnover ratios based on their unique characteristics.

For example, the grocery industry typically has a higher turnover ratio than the automotive industry due to the perishable nature of its products.

Business model

The business model of a company also impacts its ideal inventory turnover ratio.

E-commerce businesses, which often operate with limited physical storage space, tend to have higher turnover ratios than brick-and-mortar stores with large warehouses.

Product type

The type of product can also affect the ideal inventory turnover ratio.

Products with a short shelf life or that are subject to rapid technological advancements may require higher turnover ratios to minimise the risk of obsolescence.

Companies should regularly monitor and analyse their inventory turnover ratio to ensure it aligns with their business objectives and industry standards.

Striking the right balance between holding sufficient inventory to meet customer demand and minimizing carrying costs is crucial for optimising inventory management and maximising business profitability.

How to increase inventory turnover

To increase inventory turnover, there are several strategies that businesses can employ.

One approach is to focus on improving sales and marketing efforts.

This can involve implementing targeted marketing campaigns to reach potential customers and increase product awareness.

Additionally, analysing sales data and identifying trends can help businesses better understand customer preferences and adjust their inventory accordingly.

Another strategy for increasing inventory turnover is to optimise inventory management processes.

This can include implementing efficient inventory tracking systems, optimising stock levels, and reducing lead times.

Regular inventory audits can also help identify slow-moving or obsolete items that can be cleared out to free up cash and storage space.

By implementing these strategies, businesses can improve their inventory turnover ratio, reduce costs, and increase profitability.

Final thoughts on inventory turnover

Understanding and managing inventory turnover is vital to small business success.

By regularly monitoring your inventory turnover ratio and implementing strategies to optimise it, you can improve cash flow, reduce costs, and enhance customer satisfaction.

It’s important to keep an eye on industry benchmarks and adapt your practices to maintain the right inventory turnover ratio.

A high inventory turnover ratio can be a strong indicator of a healthy business, but it requires careful balancing and constant monitoring.

Implementing effective inventory management practices, leveraging technology, and staying responsive to market trends will help you achieve and sustain an optimal inventory turnover ratio.

This, in turn, will support your business’s growth and stability, ensuring that you remain competitive and able to meet your customers’ needs efficiently.