Inventory turnover ratio is a key term in inventory management. It is the primary indicator of how efficiently a company is managing its inventory.
Inventory turnover ratio, in simple terms, is the measure of how many times the inventory has been turned over in a given period of time - usually a year. This also means how frequently the company replenishes its inventory in a particular period of time. It is also known as inventory turn, stock turn or stock turnover.
Inventory turnover ratio signifies many things about a company. Apart from indicating how well or how poor a business handles its inventory, it also reveals if the inventory is obsolete or fresh. By looking at the ratio, it can be assumed whether a company overstocks or if it has deficiencies in its marketing or production line.
As a good rule of thumb, higher inventory turnover ratio indicates a sound inventory standing of a company, which means that the company doesn’t overbuy and can sell all that it buys.
In brief, this is what high inventory turnover ratio tells us-
Effective and efficient inventory managementCompany is able to sell what it buysCompany’s inventory is not obsoleteState of liquidity of the company’s inventory
The calculation of inventory turnover is important to gauge a company’s financial position because a company’s turnover is dependent upon two factors- purchasing and selling.
Each business buys some inventory and then sells it to its customers. If the company purchases more, it has to sell more. If it purchases less, it will sell less. Thus, in order to have a balanced and steady growth, a company must keep the purchase and sales of its inventory in accordance to each other and its own marketing capabilities. This is where the inventory turnover ratio comes into the picture.
Calculating your inventory turnover ratio is fairly simple. To get the ratio for a given time period, you need to find how many times the inventory was sold or used in that specific time.
The inventory turnover ratio tells us the degree in which the company’s purchasing and selling are in tune with each other.
Inventory turnover ratio can be calculated using the formula below-
Inventory turnover ratio = Cost of goods sold/average inventory for that time period Cost of Goods SoldThe cost of goods sold is usually taken from a company’s income statement and represents the costs attached with the production of the goods that are sold by the company in that particular time period. In some income statements, it is also reflected as cost of sales or cost of revenue.
Average InventoryThe average inventory is the average or the mean value of the total inventory of the company in that given period of time. If the value of inventory is not available at the beginning and end of the same period but available for different time periods, we add the last inventory of the previous period plus the current inventory of present period and divide the sum by two.
Let’s see it with an example.
In the year 2017, company ABC had an inventory of $10,000 at the beginning. At the end of the year, their inventory was $8,000. Company reported that they sold goods for $50,000.
In order to apply the formula, we need to find the average inventory for the year 2017.
The average inventory for 2017 is - 10,000 + 8,000 / 2 = 9,000.
Cost of good sold = 20,000.
Inventory Turnover Ratio = 50,000/9,000 = 5.55.
As per the formula, for the company ABC, inventory turnover is 5.55.
Now, let’s take the example of another company XYZ.
In the year 2017, company XYZ had an inventory of $15,000 at the beginning and $25,000 at the end. In their annual income statement, their sales were shown as $140,000.
Let’s calculate their inventory turnover ratio.
XYZ's average inventory is - 15,000+25,000/ 2 = 20,000.
Cost of good sold = 140,000.
The ratio is = 140,000/20,000 = 7.
Thus, company XYZ has an inventory turnover ratio of 7.
Analyzing Inventory TurnoverIn mathematical terms, this means that the company ABC clears its inventory 5.55 times in a year, or particularly, in the year 2017, while the company XYZ replenishes its inventory 7 times in a year.
If we compare the inventory turnovers of these two companies, we can safely say that company XYZ does better at managing and maintaining its inventory than company ABC.
This also means that company XYZ has better sales than company ABC, and that XYZ has lesser inventory overstocks than ABC. It can also be concluded that XYZ’s inventory is less obsolete than ABC’s.
If we do not compare the figures and analyze turnover in absolute terms, then it is difficult to say if a company's ratio of inventory turnover is a good number or not. For example, in the fast-moving consumer goods, or FMCG, sector, optimal inventory turnover is usually 8 or above, while in the aviation industry it is much lower. In the FMCG sector, goods move very fast and as a result, inventory is cleared pretty easily. In contrast, as seen in the aviation industry, aircrafts are not sold on a daily basis which is why their inventory turnover is a little low.
In general, the higher the inventory turnover ratio of a company in a given year, the better it is for the company’s future.
Low inventory turnover means low sales, too much inventory or overstocking and poor liquidity of its inventory.
Inventory turnover can be used to estimate the number of days a company will take to clear its inventory, also called the Days Sales of Inventory, or DSI.
In the above example of company ABC, the company was clearing its inventory 5.55 times in a year i.e. in 365 days.
Thus, it will clear its entire inventory in = 1/5.55 X 365 = 65.76 days.
Similarly, the company XYZ will clear its inventory in = 1/7 X 365 = 52.1 days.
DSI gives us another important insight. Since company XYZ’s inventory turnover ratio was higher than ABC’s, it will take a lesser number of days to replenish its inventory. This can be explained using the results above.
Let’s look at these findings the other way around.
Company XYZ takes 52 days to sell off its inventory while company ABC takes 66 days to do the same.
Which company performs better? Of course, it is XYZ. This can be concluded because the company that takes a lesser number of days to clear its inventory has more cash flow and better sales.
As mentioned above, a company’s ideal inventory turnover ratio varies across industries. In order to compare two companies with each other, it is important to be sure that they operate in the same business segment as to ensure the comparison will be relevant and meaningful.
A candy seller will definitely clear his inventory faster than a car seller.
Similarly, industries that have lower profit margins have higher inventory turnover ratios compared to industries with higher profit margins.
If the two companies are in the same industry then comparing their inventory turnovers can be a good parameter to understand the efficiency of their management teams and the companies’ business process.
Inventory turnover not only can be used as a benchmark set against your company’s industry, it can also be used as an indicator of your company’s profitability and holding costs.
Understanding your inventory turnover ratio can also help you to increase your profitability and reduce holding costs.
It is understood that if a company has a lower inventory turnover ratio, it means that it takes them a longer amount of time to clear their inventory; this increases their holding costs. Talking in terms of inventory turnover, a company that clears their inventory more frequently in a year will definitely have lesser holding costs than a company that clears its inventory less frequently.
Less holding costs means spending less money on ‘holding’ the inventory. This includes rent, storage costs, insurance and other utility costs. Reduction in holding costs reduces net expenses and thus increases net profits, as long as the revenue on the item remains constant.
In certain volatile industries, such as fashion or seasonal goods industries, faster inventory turnover equates to a quicker response to changing consumer behaviors.
It can be concluded that the inventory turnover ratio is a key indicator of a company’s inventory management.
Higher inventory turnover means the company manages its inventory efficiently and clears its inventory frequently in a given period of time.
Lower inventory turnover means the company does not manage its inventory efficiently, its inventory is obsolete and its sales are dwindling, which is why the company is not able to sell its inventory.
Lower inventory turnover ratio also means that the company has low inventory liquidity and spends money in holding and storing their inventory.
When a company has an inventory turnover ratio in the ideal range for their industry, it helps to booster the confidence of shareholder’s in the company’s ability to grow.
Proper inventory management is pertinent to the success and growth of a company. The right inventory management software can help to streamline your inventory process and lead to an optimal inventory turnover ratio. If you want to learn more about a mobile inventory management solution software, check out this article or try Hubworks' Zip Inventory free today