The inventory turnover ratio compares the quantity of stuff a firm has on hand, termed inventory, to the amount it sells and is an essential efficiency statistic. In other words, inventory turnover is the number of times inventory is sold during a certain period.
Why Is Inventory Turnover Important?
Because the ideal inventory turnover ratio varies depending on the business and industry, a company’s current inventory ratio should constantly be compared to its previous performance and that of other firms in its industry. A low ratio might indicate weak sales or an overstocking of inventories. Ineffective advertising, poor quality, inflated pricing, or product obsolescence can contribute to low sales. Excess inventory may be costly because merchandise sitting in a warehouse costs the company money to build but generates no income. While having a high inventory turnover ratio is preferable to having a low one, it is not necessarily indicative of a successful business strategy. A high ratio might indicate strong sales. On the other hand, a high ratio might be due to insufficient inventory levels, and if orders aren’t completed on time to match sales, the firm risks losing consumers. Inventory turnover is a good indicator of a company’s liquidity. For example, if inventory is not converted rapidly enough, a firm may have cash flow issues. A corporation with a greater, more efficient turnover rate, on the other hand, would be able to make cash quickly. Inventory is commonly used as collateral for loans by banks and creditors. As a result, it’s critical for a business to show that it has enough sales to cover its inventory purchases and that the process is well-managed. Industry-specific inventory turnover ratios differ. Automobile firms, for example, may have a lower percentage than clothes companies. The financial accounts of a company provide all of the information needed to determine inventory turnover. Both beginning and ending inventory may be noted on the balance sheet, while COGS can be found on the income statement.
Inventory Turnover Calculation
The inventory turnover ratio can be computed by dividing the cost of items sold by the average inventory for a given time. Because most organisations experience varying sales throughout the year, using current inventory in the computation might provide skewed findings; average inventory is utilised. For example, for some merchants, inventory may climb in the months leading up to the holidays and shrink in the months after the holidays. Average inventory is commonly used to determine inventory turnover to account for seasonal differences in sales. Adding the inventory at the start of the period to the inventory after the period and dividing by two yields the average inventory. In a particular period, the company’s inventory is sold and replaced a certain number of times. As a result, inventory turnover reveals how successfully a firm controls its sales-related expenditures.
- Inventory turnover is higher when a corporation sells things quickly, and there is significant demand for its products.
- Low inventory turnover, on the other hand, is a sign of sluggish sales and falling demand for a company’s goods.
- Inventory turnover is a measure of how successfully a firm manages its inventory. For example, a company’s demand for its products may be overestimated, resulting in the procurement of too many goods. Low turnover would be a symptom of this. In contrast, excessive inventory turnover suggests inadequate inventory and that the firm is missing out on sales possibilities.
- Inventory turnover also indicates whether or not a company’s sales and buying teams are on the same page. Inventory should, in theory, match sales. However, keeping inventory that isn’t selling may be costly for businesses. As a result, inventory turnover is a good indicator of sales performance and cost management. Alternatively, employing less inventory for a given quantity of revenue optimises inventory turnover.
The formula for Inventory Turnover Ratio
Inventory Turnover = Cost Of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2)
Inventory turnover may also be calculated by dividing total sales by inventory. This comparison, however, might provide deceptively exaggerated findings since sales are normally recorded at market value while inventory is recorded at cost. Because COGS indicates the complete cost of manufacturing items for sale and eliminates retail markup, most organisations use it as the numerator instead of total sales.
Particular Points to Consider
The inventory turnover ratio is a useful indicator of a company’s ability to convert inventory into sales. The ratio also indicates if management effectively controls inventory expenditures and whether they are purchasing too much or too little inventory. Inventory turnover also indicates how successfully a firm sells its products. During difficult economic times, the inventory turnover ratio may decrease. A greater inventory turnover ratio is usually preferred since it signifies that a given quantity of inventory generates more sales. When insufficient inventory fulfils demand, a high inventory ratio might result in lost sales. To determine if a company is effectively managing its inventory, the inventory turnover ratio should be compared to industry norms.