How to Master Inventory Management

The Importance of Inventory Turnover Ratio

Inventory turnover ratio is probably one of the best indicators of a company’s efficiency – in essence, showing how quick your business is at turning inventory into sales. The ratio indicates how many times particular inventory is sold during a certain period of time – over the course of a year, for example. Knowing and understanding your company’s inventory turnover rate can be a massive help in planning your future inventory purchases and optimising your stock.

Calculating your business’ days in inventory* (DII) can help you to understand your inventory turnover ratio even better because it positions the ratio within daily context. The DII value shows the average number of days it takes to sell a particular set of current inventory. Generally speaking, a higher inventory turnover (but a lower inventory turnover period) is preferable, but this can vary from one industry to another.

Knowing these numbers is important because they can have a massive influence on your profit margins. A decrease in inventory turnover can mean that fewer goods are being sold or that you’ve had to lower the mark-up rate on certain products for one reason or another, which can cause your profit margin to shrink. Investors are always interested in knowing how fluid your company’s inventory is and how fast you can turn it into hard cash. If inventory can’t be sold, it is effectively worthless.

 

Calculating Inventory Turnover Ratio

Inventory turnover ratio can be calculated easily by dividing sales or the cost of goods sold (COGS) by the average inventory. Sales and COGS values can be found on your income statement, while the company’s current inventory can be found on the balance sheet. The average inventory ratio can be calculated by dividing the sum of the beginning value and ending value of the inventory.

Because it doesn’t include the mark-up, using COGS to find your inventory turnover ratio makes the results much more realistic. On the other hand, using the number of sales is very common and might be necessary for comparative analysis.

For Example

The inventory at the beginning of the year: $100,000

The inventory at the end of the year: $120,000

Sales: $1,000,000

COGS: $600,000

Average inventory = (100,000 + 120,000) / 2 = $110,000

Based on sales:

Inventory turnover = sales / average inventory

1,000,000 / 110,000 = 9.09

Days in inventory = time period / inventory turnover = time period x (average inventory / sales)

365 / 9.09 = 365 x (110,000 / 1,000,000) = 40.15 days

Based on COGS:

Inventory turnover = COGS / average inventory

600,000 / 110,000 = 5.45

Days in inventory = time period / inventory turnover = time period x (average inventory / COGS)

365 / 2.27 = 365 x (110,000 / 600,000) = 66.97 days

High vs. Low Inventory Turnover — Pros and Cons

High Inventory 

  • Stronger sales and higher profitability
  • Lower storage risks and less expenses
  • Reduced need for financial resources for the acquisition of goods
  • An increase in solvency
  • Purchasing is tightly managed
  • A lower risk of becoming stuck with obsolete stock

Cons

  • May be an indication of inadequate inventory levels
  • Risk of running out of stock and losing sales to competitors
  • Can refer to low cash reserves to maintain normal stock levels
  • May be due to large discounts that produce only small profit

Low Inventory Turnover

Pros

  • A low inventory turnover is acceptable in situations where you have built up higher stock levels in anticipation of upcoming sales, rising prices or expected market shortages

Cons

  • Weaker sales
  • An excess of inventory
  • …which could suggest either poor inventory management or low sales
  • It ties up company’s cash and makes it more vulnerable
  • There’s a risk of inventory aging
  • Flaws in purchasing system
  • Higher storage charges
  • Obsolescence or deficiencies in the goods
  • Can indicate overall marketing problems

Tips to help you:

  1. Compare your inventory turnover, or days in inventory values against the industry average.
  2. Match your current turnover rate to previous/planned ratios.
  3. Only compare inventory turnover that uses the same approach as you (sales or COGS-based).
  4. Having a high turnover is useless unless you’re making a profit from sales.
  5. Make sure you have enough stock with a higher inventory turnover – this will help you avoid losing out on sales.
  6. Inventory purchases made in preparation for special sale events can suddenly and sometimes artificially change the inventory turnover rate.

*Also known as Days Sale of Inventory (DSI); Days Inventory Outstanding (DIO); Days Inventory; Inventory Period; Inventory Turnover Period; or simply Average Days to Sell the Inventory.

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