Inventory turnover is a financial metric that shows how many times a company turns over (sells) its inventory over a specific period or financial year. Businesses that trade and sell inventory use inventory turnover to define how well they convert the items they purchase and store into revenue. Learning how to use inventory turnover can help businesses identify how efficient their operations are.
The importance of Inventory Turnover
Calculated as a ratio, inventory turnover is a crucial indicator for operational health. A high inventory turnover ratio indicates strong sales and efficient inventory management, whereas a low ratio can indicate excess inventory, overstocking, weak sales, or haphazard inventory control.
Because inventory is classified as a current asset, businesses are evaluated on how efficiently they can convert their assets into revenue. Excess stock that sits in a warehouse, even though it has value in itself, does little else and actually harms a business. For instance, low inventory turnover ratios mean your capital is tied up in carrying costs (storage, warehousing, and insurance). It’s essential that a business can sell its inventory quickly to avoid cash flow issues.
How To Calculate Inventory Turnover Ratio
Calculating inventory turnover is straightforward: divide the cost of goods sold (COGS) by your average inventory.
Inventory turnover = cost of goods sold (COGS) / average inventory
To find your COGS and average inventory values, start off with COGS:
Cost of goods sold = (starting inventory + purchases) – ending inventory
And then calculate the average inventory value:
Average inventory = beginning inventory + ending inventory / 2
Worked inventory turnover example
To put this into perspective, let’s look at a manufacturing business.
- COGS: 100,000
- Beginning inventory: 50,000
- Ending inventory: 30,000
- Average inventory: 50,000 + 30,000 / 2 = 40,000
- Inventory turnover ratio formula: 100,000 / 40,000 = 2.5
From the calculations, the business has an inventory turnover of 2.5 over a financial year.
Interpreting inventory turnover
At face value, a higher inventory turnover ratio of 5-10 would seem generally healthy. This means a business sells its inventory more than 5 times in a financial year (or a specified period). To go even further, businesses can convert their inventory turnover ratio into the number of days it takes to sell a cycle of inventory using the days’ sales of inventory (DSI).
But the metric doesn’t tell the whole story, as the ideal inventory turnover ratio depends heavily on the industry in which a business operates. For instance, grocers have an inventory turnover of 14, and retail typically sits at 10-11. For heavy manufacturing, the average turnover ratio is lower, at 2-4.
Since sales cycles and customer demand vary by industry, a business should compare its ratio with its competitors as a benchmark. A good inventory turnover ratio will be within the industry benchmark’s average range, or higher.
How to improve inventory turnover
To improve inventory turnover, businesses need to keep tight control of their inventory management. The best inventory management software keeps everything in one place so you can monitor inventory and sales data. With the right software to help interpret data, businesses can:
- Enhance demand forecasting and analyse seasonal trends in their sales history to reduce overstocking (excess inventory) and stockouts (out-of-stock frequency).
- Monitor inventory turnover for slower-moving items and implement sales strategies, such as promotions or discounts, to increase turnover.
- Identify issues with supplier lead times and tighten them by consolidating suppliers to reduce supply chain disruptions.
This can be a powerful tool for businesses looking for effective inventory management and useful insights into their operations.
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