Turnover Ratio is a tried and true method that is all revealing: inventory management, forecasting and sales can all be somewhat determined from this formula.
What is Inventory Turnover?
Simply put, Inventory Turnover shows the time that passes from the moment a product is purchased by the company to the day it is sold to the customer.
The term Complete Turnover is used to describe that the company has completely sold the inventory of a product intended for sale, minus units that have been damaged or lost to shrinkage.
- Definition – shrinkage: any loss of inventory attributable to extraneous factors such as administrative error, cashier error, employee theft, shoplifting, theft and vendor fraud.
Consider the following, when referring to inventory turnover, it is important to understand that you must view the ultimate calculation through the scope of the particular industry and trends within that industry to determine whether a ratio is acceptable. For example, a popular retail chain specialising in the sale of reliable, low-cost FMCGs will have a vastly different ratio to that of a firm that specialises in the sale of private yachts.
Key Takeaways
- The term inventory encompasses all goods that a company has that it intends to sell – raw or finished
- Inventory turnover – how many times a company can replace inventories within a given period
- Retailers will have higher inventory turnovers – as they specialise in high volume movement of low margin goods compared to high margin industries
- Low turnover usually infers weaker sales or the possibility of a bloated inventory: too much supply compared to the demand
What is Inventory Turnover Ratio?
A simple mathematical formula that measures the number of times a company has been able to sell and replace its inventory of stock over a specified time.
It is worked out by dividing the cost of goods sold (COGS) by the average inventory (AI) of the same period: this formula is useful for commercial strategy as it can be utilised to determine the approximate number of days it takes for inventory to sell out completely.
In most industries, a higher ratio is preferable as it (usually) marks that sales are strong: though it could also show that prices are too low.
Why Are These Important?
The ratio is important because it provides an overview of your sales performance and efficiency of your inventory management, whilst also providing a platform to develop a roadmap of future commercial strategy.
Inventory turnover allows a company to measure its performance and efficiency as a high turn indicates that the company stocks desirable products and is not overspending through the purchasing of too many units, leading to wasted shelf space.
On the other hand, low turn could be interpreted as ineffective purchasing, pricing or marketing of goods: product depreciation – physically, economically and desirability – is a real possibility if products sit on shelves, tying up a companyโs cash within undesirable assets.
The high ratio is also important as it is a useful indicator of potential commercial performance profitability when the results are interpreted correctly, as faster turns mean a reduction in holding costs which yields an increase in net income and profitability: moving items quickly – such as FMCG, fashion, seasonal perishables and technology – also demonstrates marketplace agility and responsive to subconscious customer expectations.
The Inventory Turnover Formula
The process is two-fold when aiming to determine the inventory turnover ratio: first, you must determine the Average Inventory for a determined period, be it a day, week, month or year.
To work out the Average Inventory (AI):
Average Inventory Formula = (ยฃ of Beginning Inventory + ยฃ of Ending Inventory) / 2
Simplified: the total sum value of the beginning inventory, plus the total sum value of the ending inventory, then divide that total by 2. This will equate to your Average Inventory.
Now we can work out the Inventory Turnover Ratio.
To do this, we must divide the total Cost of Goods Sold (COGS) by the Average Inventory (AI):
Inventory Turnover Ratio = COGS/AI
The beginning and ending inventory figures required for the calculations described here should be found on the balance sheet for the relevant period, whilst the COGS will be found on the income statement: seek advice from your accountant should you require further guidance on this subject.
Interpreting the Formula
Carefully and accurately investigating your inventory turnover can allow you to confidently strategise and make decisions as to your future direction regarding sales performance, promotions, recruitment, purchasing, expansion and production.
Possibly the most important elements to pull from the turnover ratio are your overall sales and inventory: this can show how efficiently you make purchasing decisions and close sales. If your sales and inventory are not in line with one another – too much supply and not enough demand, for example – it will be reflected in the ratio.
Why Does Inventory Turnover Matter?
Put simply, inventory turnover is important because it is a trusted method of measuring performance: particularly when using comparisons to other seasons. As a significant amount of a companyโs capital is tied up in inventory – legally, saleable assets – if a considerable portion of stock remains unsold for an indeterminate period, cash-flow issues may ensue, leading to problems paying creditors, employees, suppliers, locums, maintenance etc.
Consider:
- In most industries, a high inventory turnover ratio is preferable IF an inventory level is not abnormally low
- Inventory turnover is typically accurate in reflecting a businessโs liquidity
- A low ratio usually indicates a bloated, overstocked inventory, poor sales or both: product quality, marketing, poor staff, excessive pricing could all contribute to a low ratio – though expected ratios differ depending on industry and typical margins
- Inventory, as a liquid asset, is usually determined as collateral by banks, creditors and other lenders as they are quicker to sell than fixed assets such as real estate
What is the Best Inventory Turnover Ratio?
As mentioned above, within most industries, a higher inventory turnover ratio is preferable to a lower figure; however, the nuance of this is the industry sector and nature of the products intended for sale, which must always be considered when attempting to draw conclusions from calculations and formulating commercial strategies to respond to any findings.
Tips to Optimise Inventory Turnover Ratio
Keep these tips in mind when you seek to improve your inventory turnover ratio and sales agility:
- Monitor trends: online and locally
- Do away for stagnating, unwanted merchandise: particularly if out of trend or obsolete
- Target marketing: know your market and secure their business
- Pre-ordering: utilise encouragement strategies to allow the business to plan purchases
Retail Inventory Management With ADP Distribution
The experts at ADP Distribution can assist you in inventory management, project management and developing your point of sale.
Our bespoke service packages include support and assistance from our experienced inventory management team for your stocktaking, PoS, storefront design and layout.
With reliable transport links, ADP Distribution is located in Birmingham: the Heart of the UK! With over 50 years of combined marketplace experience, we offer back-of-house support and guidance, as well as Third-Party Logistics and distribution to help your brand grow and expand your commercial authority.
Did you find our article on Inventory Turnover and the Inventory Turnover Ratio useful?
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