What Is Inventory Turnover Ratio and How Do You Calculate It?
Inventory turnover ratio is basically a metric that tells you how fast or slow you are selling off your products.
Essentially, inventory turnover measures how long it takes to completely sell off the stock you purchased. It is calculated by dividing the cost of goods sold by the average inventory.
A high inventory ratio indicates you are selling stock fast, and vice versa.
In this post, we will dive deeper into the concept of inventory turnover, the ideal figure you should aim for, and tips to improve it.
What is Inventory Turnover?
Also known as stock turnover(or simply inventory turns), inventory turnover is a measure of how fast or slow items are flying off your warehouse shelf. This insight lets you know the right quantity of items to stock at any given time to improve cash flow.
Streamline your processes with a tailor-made inventory management solution.
How Does Inventory Ratio Work?
The inventory turnover ratio is an essential metric that helps businesses understand how efficiently they are managing their stock. This ratio measures how often a company sells and replaces its inventory over a specific period, usually a year. A higher inventory turnover indicates a more efficient operation, where goods are sold quickly and cash flow is better managed. Conversely, a lower turnover may signal overstocking or challenges in selling products.
How to Calculate Inventory Turnover
Calculating Inventory Turnover is a straightforward process.
To calculate inventory turnover ratio, divide the total cost of goods sold (COGS) for a given period by the average inventory value. The equation is as follows:
Inventory Turnover Ratio Formula = Cost of Goods Sold (COGS) / Average Inventory.
The cost of goods sold (COGS) represents the direct costs incurred in producing or purchasing the goods that you sell during a given period.
On the other hand, the average inventory is the median value of the beginning and ending stock over a given period.
For example, if you have 1,000 units of product at the start of Q1 and 10 by the time it ends, your average inventory would be:
1000+10/2 = 505.
If COGS is $5,000, the turnover ration comes out at:
5000/505 = 9.9
Inventory Turnover Calculation Examples
Example 1: Corel Fashion, an apparel retailer that deals in women’s wear has an average annual cost of goods sold worth $360,000. And on average, each inventory intake per cycle amounts to $10,000
Their inventory ratio is as follows:
Inventory turnover = $360000/$10000
This equals 36.
Example 2: Sly Collections, a high streetwear retailer, is unable to calculate its COGS, but knows its quarterly sales value, which is about $45,000 on average. And in the 3-month period, they process inventory worth $6000 on average.
Inventory turnover = $45000/$6000
This equals 7.5.
The two examples above are hypothetical, but they at least show you how to calculate your inventory turnover ratio without needing an inventory turnover calculator software.
You will want to aim for a higher inventory turnover ratio by stocking fast-moving products and eliminating hiccups along your supply chain.
Days Inventory Outstanding(DIO)
Knowing the pace at which you sell off goods makes it easy to anticipate how long you will hold stock before selling it off. This is known as Days Inventory Outstanding, or just DIO for short.
DIO is calculated by dividing the number of days in a year by the inventory turnover ratio. In other words:
DIO = 365/Inventory Turnover Ratio.
For example, in the case of Sly Collection, whose turnover ratio is 7.5, their DIO will be calculated as follows:
DIO = 365/7.5 = 48.66 days.
Interpretation: It takes the business about 50 days to completely sell off newly purchased stock.
Six Reasons Why Tracking Your Inventory Turnover Ratio Is Important
Here are six reasons why monitoring your inventory turnover ratio consistently is important
1. Improves Inventory Management
A higher inventory turnover ratio indicates that you are efficiently managing your inventory by quickly selling products and restocking at a rapid pace. Conversely, a lower turnover ratio suggests that you may be carrying excess inventory, leading to increased storage costs and the risk of obsolescence.
2. Enhances Supply Chain Performance
Inventory turnover is closely related to supply chain efficiency. An optimal inventory turnover ratio signifies a streamlined supply chain, reducing holding costs and enabling you to respond more effectively to fluctuations in demand.
3. Improves Cash Flow Management
Effective inventory management positively impacts your cash flow. A higher inventory turnover ratio means that less capital is tied up in inventory, providing you with more liquidity to invest in other areas of the business or to address financial obligations.
4. Identifying Seasonal Trends
Analyzing inventory turnover over different periods can help identify seasonal demand patterns and plan inventory levels accordingly. This enables businesses to avoid stockouts during peak demand and minimize excess inventory during slower periods.
5. Performance Benchmarking
Comparing your inventory turnover ratio with industry averages and competitors helps you gauge your market competitiveness and identify areas for improvement in inventory management practices.
6. Enables You to Calculate Retail Prices Accurately
The key to staying profitable in business is calculating your product prices accurately. This is another area where tracking your inventory turnover ratio is beneficial.
What Does High or Low Inventory Turnover Ratio Mean?
Generally speaking, a high inventory ratio implies you are selling stock fast, whereas a low one means the opposite.
However, there are some exceptions to this rule.
If you sell high-end goods, like designer bags or jewelry, your turnover ratio will most likely lean towards the low end. The reason is that products like this are slow-moving, and so won’t fly off the shelf quickly like the regular ones.
Furthermore, an extremely high ratio can be a bad omen for your business. For starters, it can be indicative of underlying understocking problems. It could also mean your prices are too cheap, and this might lead to heavy business losses.
Ideally, you will want to keep your turnover high, but not extremely high.
What is a High or a Low Inventory Ratio?
When can you say that your turnover ratio is high or low? To put it another way, what benchmark would you use to determine a high or low ratio?
Well, what constitutes a high or low inventory ratio varies by industry. In the apparel industry, the ideal figure is between 5 and 10. This means anything south of 4 is low and north of 12 is pretty high.
What Can You Do to Remedy a Low Inventory Ratio Problem?
A low inventory turnover isn’t a death knell. You can spin things on their head and turn the tide in your favor with a little bit of creativity and persistence.
Some things you can do to remedy a low turnover ratio include optimizing your pricing strategy, doubling down on marketing/promotions and strengthening your supply chain.
Tips to Improve Your Inventory Turnover Ratio
A low inventory turnover ratio breeds a lot of problems. One is that it causes dead stocks to fill up your inventory, leading to too many unsold inventories tying down your cash flow.
If you’ve been experiencing this, here are strategies you can try to turn your fortunes around for the better.
1. Regularly Monitor Stock Levels
Frequent monitoring of stock levels and efficient inventory control are both crucial for identifying slow-moving or obsolete items. Regularly assess inventory reports to determine which products are not contributing significantly to revenue and decide whether to reduce prices, run promotions, or discontinue them altogether. By promptly addressing slow-moving inventory, you can prevent it from dragging down your overall inventory turnover ratio.
2. Negotiate with Suppliers
Establish strong relationships with suppliers and negotiate favorable terms to reduce lead times and inventory costs. Seek discounts for bulk orders or early payments to improve cash flow and ensure a steady supply of goods. Efficient supplier management can lead to faster restocking and improved inventory turnover.
3. Optimize Order Quantities
Balancing order quantities is crucial to prevent excessive stock accumulation. Employ economic order quantity (EOQ) principles to determine the ideal order quantity that minimizes holding costs while meeting demand. Striking the right balance will help you maintain optimal inventory levels and enhance inventory turnover.
4. Leverage Inventory Management Software
Invest in reliable inventory management software to streamline your inventory processes and gain real-time insights into stock levels, sales patterns, and demand fluctuations. Modern inventory management systems can help automate tasks, reduce human errors, and provide data-driven suggestions for inventory optimization, ultimately leading to improved inventory turnover. Another option worth considering is Qoblex—an inventory management software built to support growing businesses with real-time inventory visibility and multichannel integration.
What Is a Good Inventory Turnover in Days?
Ideally, you should aim for an inventory turnover of 4 to 12 days for a healthy cash flow.
Move Your Business Forward With Uphance
Using the right inventory management software is crucial for achieving the optimum inventory turnover ratio. Doing so lets you track your inventory levels at all times, monitor stock as they move along your sales channels, and see stocks selling the fastest and slowest.
What better software to use than Uphance? Uphance comes with a load of features that make managing your inventory a breeze.
Schedule a demo right away to see things for yourself.
FAQs
Inventory ratio is said to be low when it’s 1 or less, although this figure largely varies by industry and niches.
A low inventory ratio means you aren’t selling goods as fast as you ought to. If allowed to fester, your business might run aground due to tight cashflow and obsolete inventory.
A high inventory turnover ratio implies you are selling out your merchandise fast. But you need to exercise caution because you might run into stockout problems if you don’t forecast and plan inventory purchases properly.
A good inventory ratio is anywhere between 5 and 10. Of course, this varies by industry and niches.
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