How to Calculate the Inventory Turnover Ratio | Formula & Examples
As a small business owner, you should always be on the lookout for ways to improve your sales. Sure, you can try new things with marketing and ask your customers what they like. But you’re going to need cold, hard sales data if you want to know where to make adjustments. This is where the inventory turnover ratio can help. Calculating this formula can give you a clear understanding of how often you sell inventory and replace it. But first, you need to know how to calculate the inventory turnover ratio. Here at Seek Capital , we want you to have a wealth of resources to explore for improving your business. Today, we’re sharing a key component for doing just that. We’ll also show you how to figure out how many days it typically takes you to sell all of your inventory within a given period. Having this data can play a big role in how you strategize your company.
Inventory Turnover Defined
Inventory turnover ratio is simply the formula for figuring out how often a business sells and replaces its inventory. A ratio that is higher is usually a good indication that sales are good and business is at least steady. Conversely, a ratio that’s lower tells the exact opposite, and you need to adjust your business strategy to improve sales. Calculating your inventory turnover ratio is a great way to give you guidance in your business. From adjusting prices to improving your marketing strategy, your turnover ratio can teach you a lot about your business and help you make it more successful. Ideally, you want your inventory turnover ratio to be somewhere in the middle. Sometimes, a higher ratio can be an indication that you don’t have enough inventory and are possibly missing out on sales opportunities. In short, the inventory turnover ratio is a way to measure how well your business sells its inventory. With a little research, you can use these numbers to your advantage and grow your business .
A Closer Look at Inventory Turnover
Your company inventory refers to the items that you intend to sell in your store. Or, if you’re a manufacturer, inventory could be materials used to produce completed items for sale. With inventory turnover, you’re looking at the number of times that items are sold and restocked. And as outlined above, the more you sell your goods and restock them, the higher your ratio will be. As a business, you obviously want a great turnover ratio. Your inventory turnover ratio is a reflection of how well you manage your finances by converting your cash into profit. With that being said, there are situations that can cause your ratio number to be lower than usual. For instance, let’s say you overestimated demand for a particular product and ordered more than what actually sold. This would cause your ratio number to be lower than it usually is. And if you are storing inventory that isn’t selling, this can be costly to your company. Ideally, you always want your inventory to match your sales. By improving your inventory turnover ratio, you can effectively use less of your inventory. There is certainly a balance that needs to be met in order to have good business operations.
How to Calculate Your Inventory Turnover
To find out what your inventory turnover ratio is, you will need to divide the cost of goods sold (COGS) by your average amount of inventory for a given period. It’s important to use figures from the same period or you’ll end up with inaccurate data. It’s important to remember that your COGS includes things like the cost of raw materials, labor associated with goods and services, and any overhead. Understanding your business’s COGS will help you get a better grasp of your production costs. Cost of goods sold (COGS) ÷ Average inventory = Inventory Turnover Ratio For example, let’s assume for a moment that your COGS for the month of January was $5,000, while your inventory was worth a total of $1,000. $5,000 ÷ $1,000 = 5 This is an example of a solid inventory turnover ratio. With this number in mind, there are some months throughout the year that are likely to throw off your typical inventory turnover ratio, like around Christmas. It’s not uncommon for retail stores to see a higher inventory turnover ratio before major holidays . And following those same holidays, there’s a good chance that the inventory turnover ratio will be lower than usual. Due to this factor, you shouldn’t base too many changes around the figures you get for holidays. If you’re looking to better your company, it’s best to look at average data for normal operating months. This will give you a more accurate view of how your company is doing on average. If you find that you’re buying too much inventory in any given month, you’ll know that adjustments need to be made in your ordering process. Ignoring the data that you get from your inventory turnover ratio could sink you financially. You also don’t want to compare your information with that of another industry. If you have a successful competitor that is of similar size and scale as you, it may be beneficial to compare. But only if they are in the same industry as you are and produce the same or similar product. But other than that, comparing your numbers with a company that’s in a completely different industry will only serve to confound you. Now that you know how to formulate your inventory turnover ratio, let’s move on to Days Sales of Inventory. This will give you a clear understanding of how many days it generally takes you to move inventory.
Days Sales of Inventory
Days Sales of Inventory (DSI) serves to measure how many days it takes for your store’s inventory to translate into sales. To calculate your business’s DSI, you will need to multiply the inverse of your inventory turnover ratio formula by 365 (for each day of the year). Using the examples from above, let’s look at what your hypothetical DSI would be. (Average inventory ÷ Cost of goods sold) x 365 Or, using the figures from the examples above, 365 ÷ 5 = 73 That would mean that it takes you 73 days to sell all of your inventory. This puts your business’s efficiency in a different context. Calculating your inventory turnover days doesn't really give you any new data, but figuring out the number of days that it takes to sell your inventory can be very helpful in positioning your company to be more successful.
Inventory Turnover Ratio and Its Limitations
Figuring out your inventory turnover ratio is only so helpful if you completely understand the industry in which you work. If you sell shoes and you’re basing your calculations off of a soda company’s results, you’re not going to get very far in improving your business. It is therefore important to have a firm grasp on your industry. Knowing what typically sells and what doesn’t will make it a lot easier for you to make adjustments for the good of your company. If you are part of an industry that operates in a way that takes a long time to manufacture your product, you’re going to need to account for that when calculating your inventory turnover ratio. The good news is that most industries that are slow to manufacture products often bring in huge revenue once a sale is finalized. Take the automotive industry as an example. Only so many vehicles from one company can be produced each day. There is a lot of time-consuming, meticulous work that goes into putting a quality vehicle together on the production line. But when that vehicle finally sells, it brings the company tens of thousands of dollars. Now compare that to an ice cream stand. It takes mere seconds to scoop out ice cream, stick it on a cone, and place it in the customer’s hand. Obviously, there is going to be a vast difference in what each company’s figures mean to them. As such, you need to fully understand the intricacies of your business so that you can make sense of your calculations. In doing so, you will be able to make your figures work for you so that your company becomes more successful.
Summary
When you are able to calculate your inventory turnover ratio, you can start to strategize in ways that you couldn’t before. Knowing when to replenish your goods is an art that is learned over time. If you’re a new business owner, be patient. You’re bound to make mistakes at first, but it’s important that you stick with it. It is likely to take some time before you can utilize your inventory turnover ratio to its fullest potential. But when you do, you will find that it’s easier to make adjustments to your company in a way that benefits your bottom line. Sources https://www.lightspeedhq.com/blog/small-business-guide-holiday-inventory-management/ https://study.com/academy/lesson/day-sales-of-inventory-dsi-formula-examples.html https://www.toyota.co.jp/en/kids/faq/b/01/06/