There are many ways to determine the success of a business. You can scope out the foot traffic in the area, survey some of the customers, or do as the professionals do and calculate inventory turnover.
Inventory turnover measures the number of times a company sells its entire inventory during a given period. It’s a valuable metric, as it reveals how well a particular product sells and how effective the company is at managing its stock levels and cash flow.
In this post, we walk you through the basics of inventory turnover, the formulas used to calculate it, and what it means for your business. Inventory is one of the most important indications of how a business is doing, and inventory turnover provides an easy way for you to understand which products are helping drive your sales and which are dragging you down.
What Is Inventory Turnover
Inventory turnover, also known as stock turnover or merchandise turnover, is a ratio that shows how many times a company’s inventory has been sold and replaced within a given period (usually per season or per year).
Inventory is comprised of all the goods a company currently holds in stock that will ultimately be sold. While it typically refers to finished product, it can also include raw materials, components, and any parts that will go towards the production of the finished product.
From the minute a batch of inventory arrives until the last unit is sold, it counts as one inventory turnover.
Generally speaking, the higher the inventory turnover rate, the better. This means your company is selling goods very quickly and there is a strong demand for your product. Low inventory turnover rates, on the other hand, usually indicate slow sales and a weak demand for the company’s products.
However, turnovers that are too high are also not a good sign. This indicates that you’re not keeping sufficient stock levels. And not having enough stock leads to missed sales and unhappy customers.
Instead, a business needs to find the right balance between having too much and not enough inventory — and that can be done by calculating the inventory turnover ratio.
The ideal inventory turnover ratio varies by the industry. You can get an idea of some high and low values of industry-specific inventory turnovers through online resources. While those can serve as a great guide, nothing will be as accurate as crunching the numbers yourself.
How to Calculate Inventory Turnover
There are two formulas used to calculate inventory turnover. The first formula is a simple two-step process. The first step is to calculate for the average inventory, which estimates the amount of inventory your company usually has on hand. This is done by adding the ending inventory to the beginning inventory, and then dividing the number by two. The second step is to divide the total sales by the average inventory. The result is your inventory turnover.
For example, if your beginning inventory is $150,000 and your ending inventory is $50,000, your average inventory would be $100,000. If your total sales was $75,000, then your inventory turnover would be 0.75. This means your company turned over three-fourths of its inventory during the given time period.
The second formula requires an additional step, but is considered more accurate. It calculates inventory turnover using the cost of goods sold (COGS) instead of total sales. COGS is the total cost a company incurred to produce the products or services it has sold (it doesn’t include products or services that are still unsold). Using COGS rather than total sales results in a more realistic number, as the latter usually includes additional markups that inflate the inventory turnover.
The first step to get your average inventory is the same as we saw in the first formula — add the ending inventory to the beginning inventory, and then divide the number by two. The next step requires you to calculate your COGS. Do this by adding the beginning inventory to any purchases made during the period, and then subtracting the ending inventory. Then, take the COGS and divide it by the average inventory. This gives you a more precise inventory turnover ratio.
Using the same example, with a beginning inventory or $150,000, an ending inventory of $50,000, and purchases of $10,000. Your average inventory would still be $50,000 and your COGS would be $105,000. In this case, your inventory turnover is 1.05, which indicates your company turned over its inventory more than once during the given time period.
Why Inventory Turnover Is Useful
Keeping tabs on inventory turnover not only helps your business meet the market’s needs, it can also help you make better purchasing decisions, keep track of finances, and basically, do your business better.
For starters, inventory turnover indicates whether two of a company’s key departments — purchasing and sales — are in sync. Ideally, all purchased inventory should be sold within a reasonable amount of time. If there’s too much inventory and not enough sales, this creates loads of overstock, additional storage costs, and a halt in cash flow.
Inventory that is not sold is not worth anything to a company. In many cases, any stagnant inventory will eventually be sold at cost or at a loss just to facilitate turnover. Because a significant amount of money is usually tied up in inventory, if it doesn’t get sold, a company will be unable to pay its other expenses (i.e., salaries, utilities, etc.) or place future product orders.
In addition to the overall inventory turnover ratio, larger companies may find it useful to calculate the ratio for each product category or supplier, or even to calculate the turnover ratio per product. This offers further insights into the market, such as if there’s a higher demand during a certain season, or if certain products tend to move off the shelves quickly or not at all. These numbers help a company align their inventory purchasing strategy to cut costs and meet the market needs.
Seeing how inventory turnover trends change over time can be even more telling. For example, a decreasing annual turnover ratio may indicate that something requires your attention. What’s causing the decline? Do sales efforts need help to keep up with purchasing orders?
On the other hand, if turnover is increasing year to year, you may still need to make adjustments. While this indicates an increase in sales (which is definitely a positive thing!), it’s good to make sure that stock and suppliers can keep up with the demand.
Furthermore, a company’s inventory turnover is a good gauge of how easily it’s able to turn inventory into cash — or, in investor lingo, how liquid a company’s inventory is. This is especially crucial for companies seeking a loan or credit line. As inventory is a common form of collateral, a bank or creditor will need to know that inventory will be easy to liquidate.
Best Inventory Management Practices
There are many ways to adjust inventory levels in order to achieve optimal turnover rates for your business. The simplest change would be to purchase inventory in smaller, more frequent batches. For example, if you can buy a month’s or quarter’s worth of product rather than a year’s worth, this will leave less excess inventory sitting idle in your facilities and lessen the risk of losing money on anything that remains unsold.
Another good idea is to encourage pre-orders from your customers. Not all businesses can offer this, but if yours can, a good pre-order system can help to build excitement, forecast market demand, and effectively raise funds.
The ultimate aim of inventory management is to free up cash flow and storage space for new products. If managed well, a healthy flow of inventory can create a good reputation in the market and long-term success for your business.
The Bottom Line
Inventory turnover sheds light on many aspects of a company’s health — how well it meets its market’s needs, how efficiently it manages its cash flow, and how quickly it can expect to grow. By calculating inventory turnover ratio, you can help determine just the right amount of stock to keep on hand to ensure your company’s long-term success.