Companies like to keep tabs on inventory, and with good reason. Accurate, up-to-date inventory management is a solid measure of knowing whether production is meeting demand and if products are selling fast, and company executives will want to ensure new products are on hand to meet ongoing purchase demand needs.
Conversely, if products aren't selling like hotcakes, either due to lackluster demand, a sour economy, or seasonal issues (i.e., few consumers want to buy a snow blower in July, even though you'd likely get it at a discount), company decision-makers will want to slow production, keep inventories stable, and keep costs low in the process.
There is a key term in the inventory equation that more accurately measures the dynamics of inventory management over a specific period of time. It's called inventory turnover ratio, and it's a useful metric in evaluating how many times inventory "turns over" in a fixed period, as products are sold (and returned) in the business marketplace.
What Is Inventory Turnover Ratio?
Inventory turnover ratio reveals the number of times a business has sold and replaced products (i.e. inventory) over a fixed period of time.
For companies, the metric is extremely helpful in determining the number of days it takes to see that product, from the day it rolls onto loading docks to the day it's sold and the cash price is recorded in company ledgers. Inventory turnover ratio accomplished this task by dividing the days needed to record a product sale from inventory by the inventory turnover rate to figure out how long a product goes from inventory to outright sale, and helps to determine if the product should be replaced or not in the company's inventory.
That formula, known as sales divided by average inventory, provides companies with a cost blueprint, enabling businesses to optimize manufacturing, sales, marketing, and purchasing to achieve a good inventory balance going forward.
The goal of measuring your company's inventory turnover ratio is not only to measure your company's financial efficiency, but to curb inventory holding expenses. Doing so saves money on leases and rent, lights and utilities, labor, insurance, and other inventory management costs.
Why Inventory Turnover Ratio Is Important in Business
Inventory turnover goes by different names - inventory turn, stock turn and stock turnover are common terms used when evaluating inventory management issues. The inventory turnover ratio is especially important, for two primary reasons:
Stock Purchasing Outcomes
A company might overproduce and wind up with too much inventory during a fixed period. Under that scenario, a company wants to do all it can to sell that excess inventory, and boost its inventory turnover rate. Yet if the business experiences difficulty in selling that excess inventory, it absorbs high costs in the form of excess storage costs and higher labor expenses, among other expense issues.
Sales and Purchasing Issues
It's a given in corporate financial management circles that sales need to match inventory purchases as closely as possible. Otherwise, inventory turnover is thrown out of balance, and won't turn efficiently. To ensure sales and inventories are in balance, a company's purchase and sales departments must in sync. A proper inventory turnover ratio calculation can up the odds of making that sales/purchase balance happens.
The fact is, a company's survival depends on an accurate inventory turnover management measurement. If a company has a low inventory turnover ratio, that could likely mean the business is either overstocked, or that there are inefficiencies in the product development, purchasing, marketing, or sales departments. On the other side of the coin, a higher inventory ratio is deemed as a good development for a company, as it indicates good inventory turnover management.
Additionally, it's good for company decision-makers to know that the type of products sold definitely impact turnover ratios. For instance, a product that's only sold once annually, like a car or truck, has significantly higher holding costs that a product which is sold once a week or so, like soda or lettuce.
How to Calculate Inventory Turnover Ratio
The calculus for figuring out inventory turnover ratio is fairly straightforward. Basically, here's the formula:
Inventory Turnover Ratio = cost of products or goods sold / average inventory
Here's a real-world example. Let's say that annual product sales are $100,000 and inventory is $50,000. In that scenario, the company's inventory turnover is:
100,000/50,000 = two times.
Let's further assume that, during the fixed period of time measured (one year) the cost of products sold = $100,000, and the average inventory level = $50,000. Here, the inventory turnover ratio is: 100,000/50,000 = two inventory turns annually, meaning it takes about 180 days for a business to record sales and replace its inventory.
Company decision makers also should know how long, in days, it takes to clear their firm's entire inventory.
Fortunately, there's a formula for that, too. Simply take the number of the days in a year (365) and divide it by the inventory turnover rate. The outcome number is the total amount of days it will take for a business to run through its entire inventory. Consequently, a turnover rate of 2.0 means a company takes 182.5 days to clear its entire product inventory.
Limits of Inventory Turnover Ratio
There are optimal times to deploy an inventory ratio analysis and there are times it's better to avoid one. In fact, there are limits to using an inventory turnover ratio, as it's not always an optimal metric.
Here's a rundown of what factors can impact inventory ratio analysis and why:
- When the data is misleading. If the data leads to an inaccurate outcome, and the results call for carrying lower inventories, that scenario could lead to lower product sales, as inventory won't meet heightened demand.
- Annual turnover rates may differ. Turnover rates for a company selling fast-moving merchandise like soda or socks will likely differ from companies that sell slower-moving products like trucks or commercial refrigerators. Thus, depending on the industry you're in, it helps to understand the realities of sales and inventory.
- Discounts and deals. Often, companies will resort to offering steep discounts to thin out inventory. That strategy may well move inventory, but it can cut deeply into a company's bottom line.
- Timing an issue. When you're trying to actually peg your inventory turnover rate, timing can be thrown out of balance due to discounts and special product promotions, which can alter ratio outcomes.
- Low margin versus high margin, Typically, low-margin industries will show higher inventory turnover ratios than high-margin business sectors. That's due to the fact that lower-margin companies have to balance lower per-unit revenues with stronger unit sales volume. That's also why the best inventory turnover ratios are industry-specific.