Inventory turnover rate plays a great role in determining the profit or loss of businesses.
It also helps businesses to make crucial decisions relating to their sales. Ideally, the turnover ratio of any business should neither be too high nor low. However, this depends on one’s industry type and the buying habits of one’s consumers.
Read on to understand what the inventory turnover ratio is, and learn how it can be applied to your business today!
Table of Contents
What is an inventory turnover ratio, and why is it important?
How to calculate an inventory turnover ratio?
What is a good inventory turnover ratio?
Final thoughts on inventory turnover ratio
What is an inventory turnover ratio, and why is it important?
The inventory turnover ratio measures the number of sales and restocks a business does in a particular time frame. Also, you can use the formula to calculate the number of days it will take to sell the inventory.
In calculating the turnover ratio, the cost of goods sold is divided by the average inventory for the same period. High ratios indicate strong sales, whereas low ratios are less desirable; though exceptions exist.
As the inventory turnover ratios may rise or decrease due to circumstances, it allows businesses to make important decisions. Inventory turns also help to identify underperforming units, ultimately improving financial health and increasing profitability.
An inventory turnover ratio example is the Walmart trend. Walmart’s yearly trend of measuring its inventory turnover ratio has helped to improve its business efficiency, reduce operating costs and boost profit.
Tracking inventory turnover can help businesses improve various aspects, including pricing, production, warehouse management, marketing, and purchasing.
Let’s assume you sell a product of about $20,000 yearly with an investment of $25000 gross profit. How do you calculate your turnover ratio?
Well, there are two ways to go about this.
You can either buy a product for $20,000 at once or buy it on a small scale. This means that you can make your purchase four to five times a year with the same amount of profit but with an investment of $15,000 every time you restock.
The advantage is that every time you make small purchases for your store, you can invest in other aspects of your business to generate additional profits.
See a list of inventory turnover rates from our example:
| Cost of Goods Sold Yearly | Inventory Investment | Inventory Turns |
| $20000 | $20000 | 1 |
| $20000 | $10000 | 2 |
| $20000 | $5000 | 4 |
| $20000 | $2500 | 8 |
While this investment is a smart way of calculating the turnover ratio, it’s best for specific businesses–especially those with low inventory turnovers. Why? Because they allow investments to be spread across the business rather than spent solely on goods that may depreciate.
How to calculate an inventory turnover ratio?
One’s ideal inventory turnover ratio solely depends on the size of the business, services offered, and supply chain. Hence, inventory turnovers may be seen as benchmarks guiding businesses to understand customer demand, pricing, and how to scale.
To evaluate your business inventory turnover, understand how to calculate it using the inventory turnover ratio formula.
Here’s how to do this:
1. Calculate the cost of goods sold (COGS)
The cost of goods sold refers to the direct cost of goods a business sells — for example, the cost of materials and expenses needed for producing products.
Calculating the COGS to write off expenses and assess your business’s financial health is important. You can calculate the value of the cost of goods sold by subtracting the total profit made from the business sales revenue.
Calculating the cost of goods sold (COGS) also helps to determine your gross profit by measuring the cost you’ve incurred in your business.
After calculating your COGS, sum up your business average inventory.
2. Calculate the average inventory
The average inventory estimates the value of your inventory in at least two or more accounting periods. To calculate the average inventory, sum up the inventory at the beginning and end of an estimated period and divide them by two.
You may also use ending stock as an alternative to average inventory if your business doesn’t experience seasonal fluctuations. Divide the monthly inventory by 12 to obtain the annual average.
Then, calculate inventory turnover ratio by dividing the cost of goods sold by the average inventory.
Your inventory turnover ratio ultimately provides insight into the market profitability of the overall inventory mix or certain stock. Successful businesses can have several inventory turnover days yearly, but this varies by product category and market industry.
What is a good inventory turnover ratio?
A good inventory turnover analysis should balance strong sales and restock rates.
It’s necessary to have a good inventory turnover ratio to thrive, irrespective of the business type. This’ll tell you whether or not to scale your business. Once you’ve figured that out, you can have better control over pricing and leverage subsequent sales opportunities.
Inventory turnover ratio analysis also streamlines the business supply chain to eradicate inefficiencies that affect sales and profits.
However, these turnover ratios differ by industry. For example, businesses in consumer-driven sectors are likely to have high turnovers. By contrast, high-end luxury businesses typically see low inventory turns and longer production times.
Here are some factors that affect inventory turnover ratio in different industries:
Low-profit margin industries: Consumer-packaged businesses like grocery stores or retailers must maintain high inventory turns to maintain profit. Why? Because their business is driven by high, consistent demand.
So, rather than increase the profit margin on one item alone, these businesses make compound profits with consistent inventory turns. Their low margin makes it easy to sell and restock inventory, matching demand with supply.
Industries with high retention costs: For example, consumer electronics and machinery companies must maintain high inventory turnover rates. The reason is simple. Their industry is competitive and rapidly evolving with new technology. So, holding on to old stock could potentially cost them money, which is why they’re expected to sell off goods and restock rapidly.
High-end luxury businesses. For example, high-end fashion businesses like luxury jewelry sellers or handbag sellers might struggle with low inventory turnovers because of the kind of customers they cater to.
For this reason, they must optimize their inventory to accommodate inefficient supply chains, as well as other inefficiencies.
An inventory turnover ratio can be extremely high or low, depending on one’s business niche. In most industries, the ideal inventory turnover ratio is between 5 and 10, which means the company sells and restocks inventory every one to two months.
Businesses that sell perishable goods will require a higher ratio to avoid inventory losses caused by spoilage.
Thus, it’s imperative to enhance turnover ratios by adjusting pricing strategy, forecasting, and automating business purchases.
3 Ways to apply the inventory turnover ratio
As highlighted above, there are good reasons why businesses should calculate their inventory turnover ratio.
But let’s take a look at three ways to apply the turnover ratio to your business for the best results:
Inventory turnover by product or category
Before calculating your turnover ratio, you must gather and calculate your products based on their category. It gives you an idea of whether or not to stock up on certain goods. It also determines if your inventory turnover ratio would be high or low.
Seasonal inventory turnover
As we’ve mentioned, your inventory turnover ratio is dependent on the type of goods you sell. For example, if you sell seasonal goods like winter clothes, you should calculate your season inventory span before stocking your business. It avoids having excess products that may not be of use and gives you the exact amount of times you need to restock.
Total inventory turnover
Calculating the total inventory turnover for your business is necessary to evaluate how many units of each item you will need to stock for certain periods.
However, to get a precise inventory turnover, you must tailor your turnover ratio and calculate it within your defined categories. This avoids inaccuracy as products have inventory turnovers depending on their niche.
Final thoughts on inventory turnover ratio
Your business can find the perfect balance between pricing, inventory management, and making profits with ideal inventory turnovers.
Ensure a smooth supply chain by optimizing warehouse operations to speed up the inflow and outflow of goods. This will improve delivery and inventory turns in the long haul.
Also, establish good pricing strategies to boost your inventory turnover ratio. Once you leverage that over competitors with similar pricing, it increases your goods’ demands and helps your business attain higher profit margins.
