Determining inventory turnover measures how quickly a company sells its inventory or stock of goods. It is calculated by dividing the cost of goods sold (COGS) by the average inventory for a given period.

A high inventory turnover ratio indicates that a company is operating at optimal levels and efficiently selling its inventory. While a low turnover ratio may show that a company is in difficulty and struggling to sell its goods.

There are some attractive benefits to having a high inventory turnover ratio. It can help a company generate more revenue by ensuring that inventory is always moving and being shipped to customers, not sitting idle on shelves or in warehouses. This helps businesses to reduce cycle times and save on storage and carrying costs, as excess inventory is costly to maintain, and minimize problems caused by storage capacity and bottlenecks restricting throughput.

bottlenecks and inventory turnover ratio

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A high turnover ratio can help a company maintain good customer relationships. When a company has a steady inventory flow, it can better meet customer demand and avoid stock shortages. This can help improve customer satisfaction and loyalty.

On the other hand, a low inventory turnover ratio can cause problems and a red flag.  It could indicate that inventory needs to be handled and managed effectively, and as a result, the business may be missing out on potential sales. In some cases, a low inventory ratio may also indicate overstocking, leading to businesses holding excess or unnecessary inventory and raising additional carrying costs.

Finding inventory in the backroom is not always a joy.

– Doug McMillon 

Accurate inventory turnover is an important metric for companies to track. By regularly monitoring and managing their inventory levels, companies can strive to achieve a healthy inventory turnover ratio, manage expenditures, and maintain profit margins.

How to calculate the inventory turnover ratio

Calculating a company’s inventory turnover ratio gives a good indication of business health and there is a mathematical formula to find the ratio. To make the calculation, companies will need to know two things –

  1. Cost of goods sold (COGS) and the
  2. Average inventory for a period of time.

COGS is found by examining the company’s income statement. It is typically listed as a separate line item and includes the cost of materials and labor used to produce the goods sold during the specified period.

The company’s balance sheet will contain information about average inventory levels. The ratio is calculated by taking the inventory at the beginning of the period and adding it to the inventory at the end of the period and dividing it by two.

Once these two values have been identified, the inventory turnover ratio can be calculated by dividing COGS by the average inventory.\

formula to calculate inventory ratio

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Inventory turnover or turns is an important metric for companies to track, as it can provide insights into the efficiency of their operations and highlight demand for products. By regularly monitoring and managing inventory levels, companies can strive for a healthy inventory ratio to remain in line with business goals and reveal opportunities for improvement.

What is a perpetual inventory system?

There are two main types of inventory tracking methods, periodic and perpetual.

  • A periodic system monitors and tracks goods on hand at set periods of time.
  • A perpetual inventory system is a method of tracking and managing inventory in which inventory levels are continuously updated as goods are sold or purchased.

It is regarded as a more efficient and superior system than periodic tracking, as it effectively monitors stock levels in real-time through all cycle stages.

With a perpetual inventory system, the inventory records are updated each time a sale or purchase is made, and the use of software tools such as Oracle NetSuite and Zoho provides visibility into inventory with platforms and cloud-based applications. This means that the system always has an up-to-date record of the inventory on hand, as well as noting outbound inventory that has been sold or inbound inventory which is on order.

Perpetual inventory management offers a number of advantages over a periodic system. It allows inventory levels to be tracked with high levels of accuracy, which can help prevent stock shortages and overstocking. It also provides real-time visibility into inventory levels, that can be used for forecasting, cost modeling, and decision-making.

Additionally, a perpetual inventory system can help a company save time and reduce errors by automating many of the tasks involved in inventory management. This reduces the need for manual labor and frees employees to focus on other important tasks, such as customer service and sales.

A perpetual inventory system is a valuable tool for companies that want to manage their inventory and consistently improve their operations.

Why inventory ratio is important

Understanding inventory ratios provides insights into a business’s inventory management practices and overall business performance. These ratios can help a company identify any potential issues with inventory and goods management and take steps to address them. It can help to keep stock levels down and free up capital that may otherwise be tied up in held goods.

Inventory ratios can help a business to compare its performance to that of other companies in the industry. Accessing valuable information on industry trends can help a company benchmark its own performance and take steps to maintain a competitive market edge.

When evaluating an organization’s financial health investors and analysts will frequently turn to inventory ratios to gain a better understanding of the company’s operations. The efficacy of inventory management can reveal how well the business is performing and highlight potential problems.

Business cycles are typically in the grasp of inventory cycles and heavy industry cycles.

–  Paul A. Volcker 

Improve inventory ratios

Organizations that focus on improving inventory ratios do so for a number of reasons –

  • Lower COGS
  • Improved profits
  • Operational efficiency
  • Expenditure reduction

Better inventory ratios impact the organization in many different ways, from staff salaries to customer satisfaction improvements to turnover ratios can underscore an efficient operation and a stronger financial position.

Inventory management improvements mean that businesses will need to focus attention on things like automation tools and warehouse processes including –
Ordering models

Reducing the amount of inventory on hand can be achieved by implementing models such as JIT – just-in-time inventory management, to order only the needed inventory. This reduces the amount of inventory stored and prevents unnecessary spending.

Accurate forecasting

Accurate forecasting avoids overstocking or understocking inventory, reduces cycles times, and improves the quality of service.

Software implementation

Inventory management software tools like Freshservice and BigCommerce help organizations track and manage inventory more efficiently.

Audits and reviews

Regularly reviewing and auditing inventory identifies excess or obsolete inventory, which may then be disposed of or sold to free up valuable storage real estate.

Conclusion

Understanding and calculating the inventory turnover ratio are important for businesses because it provides a metric that clearly assesses the efficiency of an inventory management system. Monitoring and improving the ordering, handling, and storage of goods will ultimately lead to a more efficient and profitable business, supporting better customer satisfaction and higher profitability.