Inventory turnover refers to the period that passes from the day an item is purchased to the day it is sold. One complete turnover denotes that the company sold the stock it purchased except the items that were lost to damage or shrinkage. Inventory turnover is important for companies in various areas from manufacturing to pricing and supply chain management. The inventory turnover ratio also tells a lot about a company’s inventory management, sales and marketing. Every company needs to know how fast products are moving off the shelf. While some products may sell faster, others may move very slow and require deep discounts to be sold. Turnover calculation affects various critical decisions related to marketing and pricing.
Inventory Turnover Ratio
It is a financial ratio that denotes how many times a company sold its inventory relative to its cost of goods sold during a given period of time. To know how much time a company takes to sell its inventory one can divide the days during the given period with the inventory turnover ratio. For example, if you want to calculate the inventory turnover for Walmart for a fiscal year, you can divide 365 or the days in a fiscal year with its inventory turnover ratio. The result will give you the number of days for one complete turnover at Walmart.
Knowing the inventory turnover ratio helps businesses make critical decisions in several areas including manufacturing, pricing, marketing, and sourcing. It is one of the leading efficiency ratios that determines how efficiently a business uses its assets.
To offset the effect of seasonality on inventory turnover ratio, one can use the average value of inventory. The average value of inventory means the average value of inventory over a specific period, which can be obtained by adding inventory value at the end of a specific period and that at the end of the prior period and then dividing by two.
The reason that Cost of Goods Sold is used to determine inventory turnover and not sales is because inventory is typically valued at cost. The sales figures on the other hand, will include the mark up. COGS is also known as Cost of sales.
The formula to obtain the inventory turnover ratio is as follows:
Inventory Turnover ratio = COGS/Avg. Inventory
Where COGS means Cost of Goods Solved.
And the formula to determine Avg. inventory is as follows:
Average Value of Inventory = (beginning inventory + ending inventory)/2
Fundamentally, the inventory turnover ratio is the measure of how many times the inventory is sold and replaced during a given period of time.
Importance of Inventory turnover ratio
Inventory turn is important for several reasons. Slow inventory turn generally denotes lower market demand for certain items. In such a situation, the company can change its pricing strategy, offer discounts, or change the product mix. Companies need to keep their product mix aligned with customer demand in order to maintain a healthy growth rate. On the other hand, fast turn is a sign of increased demand for particular products or a mismatch between the company’s purchasing strategy and customer demand. To address such a situation, the company can employ various strategies including increasing prices, increase orders, diversify suppliers, or invest more in marketing of certain products.
What Inventory turnover ratio does is to measure how often the company replenishes inventory relative to its cost of goods sold. A higher inventory turnover ratio is a sign of good financial health and better sales. In some cases, it can also be a result of understocking. So, companies must always have sufficient inventory to support strong sales.
A lower inventory turnover ratio indicates weaker sales or overstocking. It can also indicate poor merchandising strategy or an issue with the marketing strategy. If inventory turnover ratio declines, it may indicate lower demand, which means the company will need to reduce output.
The rate at which a company can turnover inventory is a critical indicator of business performance. The retail businesses that have faster inventory turnover generally outperform their rivals. The problem with inventory remaining longer in stock is that it drives holding costs higher and the likelihood of its sales also diminish as chances of customers returning to shop for the product declines.
For businesses dealing in perishable goods, the inventory turnover ratio holds a special importance. Managers will need to look at this piece of data to maximize the sales of perishable goods or goods that are time sensitive and may become obsolete in the next season. For example, groceries, fashion products, automobiles, magazines, etc. These products are time sensitive or perishable. New automobile models keep coming to the market and fashion cycle also keeps changing.
Generally, a higher turnover ratio denotes stronger sales and is considered good for the financial health of a business. Similarly, lower turnover ratio denotes weaker sales or diminished demand. However, in some cases this does not hold true. In the case of high-end products, they tend to have lower inventory turnovers. If the inventory turnover ratio is too high, that is also an indicator of a problem since it means the company is not buying enough to support sales or the business is not generating as much profit as it can. In such a case, an increase in price can stabilize the ratio and improve unit margins.
The Inventory Turnover Ratio also has certain limitations. First of all, the ratio cannot be used to compare the performance of two companies from two different industry sectors. It is because, the inventory turnover ratio differs widely by industry. Inventory turnovers are higher in the case of high-volume low margin sectors and lower in case of low volume high margin sectors. For most industry sectors, the ideal inventory turnover ratio lies between 5 and 10 which means companies sell and replace inventory every 1 to 2 months.
Another critical factor to note is that if the inventory turnover ratio increases due to heavy discounts it will cause profitability and ROI to suffer.