You can assess the marketability and effectiveness of your products by checking the inventory turnover rates for all of your products.
An essential indicator of how well your business is doing is inventory turnover. With it, you can make more informed decisions about production, product acquisition, inventory management, marketing, and customer sales.
Strong sales or a lack of inventories to sustain those sales at that rate are indicators of a high ratio. On the contrary, a low ratio shows weak sales or market demand.
In any case, understanding the inventory turnover ratio can help you define the path for your business.
What is inventory turnover?
Inventory turnover can be defined as a financial measure that indicates how frequently a company turns over its stock in relation to its COGS (or cost of goods sold) over a specific period of time.
The number of days in the period—general, a fiscal year—can then be divided by the inventory turnover ratio to determine the average number of days it takes for a business to sell its goods.
Businesses can improve their strategies on pricing, production, promotion, and purchasing by using the inventory turnover ratio. It is among the efficiency ratios used to gauge how well a business uses its resources.
Businesses can make better choices in a range of areas, such as pricing, production, promotion, procurement, and warehouse management, by measuring and calculating inventory turnover.
In the end, the inventory turnover ratio gauges how effectively the business makes revenues from its inventory. There are several KPIs that can offer information on how to boost sales, enhance the marketability of specific stock, or optimize the overall mix of inventory.
If you look at a business’s balance sheet and revenue statement, you can avoid a lot of problems while looking for ITRs. The balance sheet will show inventory balances, but the income statement frequently includes COGS. Simply enter the values into the calculation in these two documents.
If you’re comparing data, remember that some experts replace total yearly sales with the cost of goods sold. With the addition of a company’s markup, this calculation is essentially the same. In contrast to equations that utilize the cost of items sold, this implies it may have a different outcome.
Although none is superior to the other, make sure your evaluations are fair. You shouldn’t calculate the ratio for one firm using yearly revenue and another utilizing cost of goods sold. You wouldn’t really get a feel of the way the two compare from it.
Inventory Turnover Ratio Formula
By dividing a company’s cost of goods sold by the average inventory value over the same period of time, inventory turnover calculates how effectively a business uses its inventory. For retailers, this efficiency ratio is particularly significant.
Inventory Turnover = Cost of goods soldAverage Value of Inventory
The average inventory value is applied to counteract the impacts of seasonality. It is determined by summing the inventory values at the ends of each period and the previous period, then dividing the result by two.
Cost of sales is another name for the cost of goods sold. The formula for inventory turnover is used by analysts to calculate COGS rather than sales since inventory is normally valued at cost while sales include the business’s markup.
Some businesses may substitute sales for COGS when calculating the ratio, which would likely skew the results.
Depending on the product you’re selling and your sector, you can figure out the best ratio. Like toilet paper, certain products are sold right away.
Painting, for example, might take considerably longer to sell than other commodities. When the typical turnover rate for food stores is 15, an artwork might only have three. Greater profit margin companies frequently have lower inventory turnover.
You should evaluate your inventory turnover rate in light of how other companies operating in your sector are doing to determine if it is positive or negative. To put it another way, evaluate your apples against other apples, not mangoes or oranges.
Generally, you want to have a higher inventory turnover rate. An increased rate might mean one of two factors:
- Sales are reliable: Inventory is being sold by your company profitably and successfully.
- There is not enough stock: You can lose sales if you run out of stock as a result of consuming things too rapidly.
On the other hand, in case your inventory turnover rate is too low, then you might face the following issues:
- Overstocked: You could be incurring significant storage and holding charges as a result of your excess.
- Decline in sales: Your company isn’t making enough sales.
- Inadequate marketing: Your marketing is ineffective if you can’t properly connect with and attract consumers.
If it indicates a stockpiling of goods in advance of supplier price increases or rising demands, a low inventory turnover ratio could be advantageous during inflationary periods or supply chain disruptions.
During the initial year of the COVID-19 epidemic, retail stocks dropped precipitously, leaving the sector struggling to satisfy demand.
A key indicator of a company’s performance is how quickly it can turn through its inventory.
Retailers who convert inventory into sales more quickly typically beat similar rivals. An inventory item’s holding cost increases, and its chance of being purchased again decreases the longer it is on hand.
A reduction in the inventory turnover ratio may indicate a drop in demand, which would prompt companies to cut back on production.
Example of Inventory Turnover
Imagines you run a bookstore and are attempting to calculate the inventory turnover ratio for one of your best-selling items.
You have a $20,000 COGS. Your initial inventory is $5,000, and your final inventory is $1,000; as a result, the average inventory is $4,000 ($5,000 – $1,000 and next divided by 2)
When we enter those figures into the formula, we acquire:
$20,000 (your COGS) divided by $4,000 (your average inventory) = 5 (inventory turnover)
In other terms, over the duration of the year, you turned the inventory 5 times for that item. From that now, you can calculate the average number of days needed to sell all of your inventory at once. Divide 365 days by 10 (the inventory turnover rate).
365 / 10 = 36.5
In this case, the typical inventory ($2,000 worth of items) is sold through in 36.5 days. This figure will help you determine how much inventory you will need to order in the upcoming days and the number of sales you can expect during the upcoming calendar year.
The Importance of Inventory Turns
For numerous reasons, inventory rotations are important. A sluggish turn may signify a decline in market demand for particular goods, which can influence a company’s decision to adjust the price, provide incentives to assist customers to use up inventory more quickly or alter the mix of products it will provide for sale in the future.
These are all crucial decisions since a business must maintain its product range in line with consumer demand in order to stay competitive and financially stable.
For perishable and other time-sensitive commodities to be sold as efficiently as possible, inventory turnover is a crucial piece of information. Examples include publications, food, clothing, and automobiles.
Particularly when the season’s change and shops refill accordingly, an excess of cashmere sweaters may result in unsold stock and lost revenues.
Obsolete inventory, sometimes referred to as dead stock, is such unsold goods.
A quick turn could be a sign that a business’s purchasing strategies are not catching up with the market demand. There are delays in the supply chain, or there is an increase in demand for a specific product.
This information can support a business in making decisions on price increases, increased orders, supplier diversification, prominent product placement in marketing, and the purchase of extra related inventory, among other options.
A similar approach to comprehending inventory needs while balancing supply and demand is material requirements planning (MRP).
8 Ways to Improve Inventory Turnover for Your Business
We have some tips if you’ve employed the inventory turnover ratio calculation and are aware that your averages may be better.
Pick goods that are in high demand
What do you sell that already generates a lot of buzz and has a high rate of turnover? Perhaps you might look for comparable goods to sell to your consumers.
Compile similar inventories
By locating related goods, “inventory groupings” may be formed. You can assess whether they perform well on the shelves by putting them in the same category. This might assist you in forecasting future product orders and identifying trends.
Adopt an innovative approach to marketing
Ensure your campaign is set to target your potential customer. Inform them of your ability to tackle their particular issues and the greatness of your suggested answer. Make folks eager to acquire what you have to offer by getting them fired up about it.
Dispose of items you can’t even sell
You might want to think about getting rid of a product if it has been taking up that space or storage facility but isn’t doing well in sales. You are losing money if it is merely taking up precious space.
Revise your price strategy
Pricing should be adjusted to maximize profitability on in-demand items and to release capital by selling off aging inventory (also called dead or obsolete inventory). If products simply won’t sell, think about giving the stock to a charity while receiving a tax deduction or selling it through a different channel.
Your pricing may be too high if you’ve previously followed all of the other advice on this list and you’re still not getting any sales. Compare your rates to those of similar companies and goods in your sector. Alter your pricing to become more competitive if rival companies are charging significantly higher or lower prices.
Review or update your industry ranking
Are your inventory turnover rates compared to the others in your sector? When you see new patterns in your inventory ratios, are there any prospects for you to take a stronger strategic stance on competing goods? By effectively managing your inventory, you may grow your market share and position within your sector.
Boost your forecasting
Revenue numbers as well as inventory reports provide the much-needed real data that improves the accuracy of inventory forecasts.
This information may also be used to forecast future sales by recommending adjustments to your product mix or new methods to bundle products to move slower-moving inventory at potentially better margins.
Make purchase orders automated
Automation increases productivity and could reduce expenses on its own. However, you have even greater success when you combine it with an order management system that enables the reordering of merchandise that performs well to ensure that it is always in stock.
To improve control and reduce mistakes, think about implementing an inventory software system that will automatically create purchase orders for your purchasers to approve.
Inventory turnover ratios are crucial for retailers because they can only be used to compare similar businesses.
While a greater ratio implies good sales but might also be an indication of insufficient inventory stocking, a comparatively low ratio indicates either weak sales or surplus inventory.
Keep in mind to adopt the technology. You can use software to identify the ideal level of supply and demand so that you can order the right amount of inventory at the right time.