If you have a business that can be big or tiny, you must maintain an inventory turnover ratio for growing your business.
If you do not properly maintain the inventory turn ratio, you will have to face trouble in the future such as not paying lenders, suppliers and overhead costs etc.
What is Inventory Turnover?
The inventory turnover is an activity ratio and also called a 'stock turnover ratio' that shows the number of times a company has sold and replaced its inventory in a year.
The liquidity positions of a company can be tested through this ratio. Planning for fixing different inventory levels can be made by the management of a company with the help of this ratio.
It is also known as the inventory turnover ratio that establishes a relation between the cost of goods sold and average inventory.
Inventory Turnover Ratio Formula
The inventory turnover ratio formula is calculated by dividing the cost of goods sold by average inventory.
Inventory Turnover Ratio = (Cost of Goods Sold / Average Inventory)
Cost of Good Sold
The cost of goods sold or COGS is a cost incurred from directly manufacturing a product.
It includes direct materials, direct labours or factory overhead which are directly connected with the production of the good. The COGS is reported on the income statement of a company.
There are two ways we could calculate the cost of goods sold as follows.
1. Cost of Goods Sold Formula = Sales - Gross Profit
2. Cost of Goods Sold Formula = Opening stock + Purchase - Closing stock
Average Inventory
Average inventory is the average cost set of goods between two or more specified periods.
It takes into account the opening inventory and closing inventory of the same year. Average inventory calculated on a monthly or quarterly basis.
Average Inventory Formula
The average inventory formula is given below:
Average Inventory = (Opening Inventory + Closing Inventory) / 2
Inventory Turnover Example
Suppose, It is an ABC company. Here is some information about the ABC company.
| Particular | Amount (Rs) |
| Sales | ₹ 20,00,000 |
| Gross profit | ₹ 10,00,000 |
| Opening stock | ₹ 2,00,000 |
| Opening stock | ₹ 2,50,000 |
Cost of goods sold = (20,00,000 - 10,00,000)
Cost of goods sold = 10,00,000
Average inventory = (2,00,000 + 2,50,000) / 2
Average inventory = 2,25,000
Hence, Inventory Turnover = (10,00,000 / 2,25,000)
Inventory Turnover = 4.45 times
Inventory turnover of 4.45 means that ABC company can sell its inventory about 4.45 times during the year.
What are the differences between inventory days and inventory turnover?
The inventory days helps to calculate the number of days taken by the company to sell its inventory.
Inventory Days Formula & Calculation
It is calculated the following way,
Inventory Days = (365 / Inventory Turnover Ratio)
Inventory Days = (365 / 4.45)
Inventory Days = 82 days
The inventory days is 82 means ABC company can sell its inventory within 82 days of production.
As a rule of thumb, the lower the number of days taken for the company to sell its inventory, the better is its efficiency.
A lower number indicates the company to sell its inventory soon.
Inventory Turnover Ratio Analysis
The inventory turns is an activity ratio that measures the efficiency of the management regarding inventory management and the latitude of the rapidity of movement of inventory for a specific period.
A lower inventory turnover ratio indicates weak sales and high inventory. A lower ratio shows the company is not marketing its product efficiently or if a low inventory turnover ratio is due to excessive inventory at the end of the year, then the company is incurring a high cost to maintain the inventory. A very lower ratio indicates unnecessary blockage of working capital.
A higher inventory turnover ratio shows inventory or stock has sold out rapidly and inventory management is more efficient. A very high ratio may reveal a shortage of working capital and a low inventory level of a company.
There is no ideal figure and it depends on the industry standards. As a rule of thumb the higher the inventory turnover ratio, the better it is.
Investors prefer higher ratios. It is imperative to remember to compare companies within the same sector and find out a trend of the last few years.
How to optimize Inventory Turnover?
There are several ways to improve their inventory turnover rate as follows:
1. Get used to reviewing the business's pricing strategy and assess what will happen to the overall rise in selling price.
2. Increase demand and sales for inventory through targeted and use of generously planned and costly marketing campaigns.
3. Don’t tax products with low turnover ratios on your manufacturing process and storage costs.
Focus on the products which have enough demand in the market and that makes more sales.
4. Sales through this are equal to inventory turnover but usually have a smaller time frame. Always higher sales mean a higher turnover ratio.
5. Enhanced forecasting precision by sorting inventory and observation directions.
6. Use inventory management software to get the current updates of inventory and assist you to prevent overselling and underselling etc.
What are the limitations of Inventory Turnover?
Inventory turnover has few limitations that should be aware of the investors. The limitations are following:
1. A higher inventory turnover indicates the amount of inventory may occur in loss of sales and customers' needs may not be reached on time.
2. The average inventory level for the period may suppress crucial information about the company.
3. A company could manipulate the inventory turnover rate by giving sales or rebates.
4. Often the inventory turnover ratio cannot inform the seller of the actual predicament of the business.
FAQs
1. How to calculate inventory turnover?
Inventory turnover is a measure of how fast a company has sold and replaced its inventory in a year. The inventory turnover ratio can be calculated as follows:
First of all, find out the total cost of goods sold from the company's annual income statement.
Secondly, Calculate the average inventory, by adding the beginning inventory and ending inventory balances for the year, and divide by two.
Ultimately, divide the cost of goods sold (COGS) by its average inventory.
Inventory turnover has another formula is given below;
Inventory Turnover Ratio = Sales/Average Inventory
This Formula doesn't provide an accurate scenario of a company. Because sales are based on selling price and inventory is based on the cost price. The two items are not comparable to each other.
2. What is a good inventory turnover ratio?
A good inventory turnover ratio depends on the industry. An ideal inventory turnover ratio between 4 and 6 is normally a good sign that restocks rate and sales are equalized but every business strategy is different.
A good ratio means that your products will not run out and will not fill the storage space of the items sold in bulk.
Inventory turns to help you to either keep your business away from red or determine what your customers want and need.
The inventory turnover ratio needs to be analyzed relative to a company’s industry and rivals to inform whether companies are good or bad.
3. Is high inventory turnover good or bad?
A company with a high inventory turnover rate is always suitable. A higher inventory turnover indicates inventory or stock has sold out quickly and inventory management is more efficient.
A very high ratio may reveal a shortage of working capital and a low inventory level of a company.
Hence, a high inventory turnover diminishes the risk factors that their inventory will become unsellable for the losses, stolen or technical inconsistencies.
4. What does an inventory turnover ratio of 5 mean?
The inventory turnover ratio shows the number of times a company has sold and replaced its inventory in a year and improved the liquidity position of a company.
An inventory turnover ratio of 5 means that a company can sell its inventory about 5 times during the year.
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