If you’re a business owner, at some point you’ve likely asked yourself, “What is a good inventory turnover ratio?” Indeed, it’s one of the most common and essential key performance indicators (KPIs) for businesses. For some other KPIs, check out Sekure’s recent article on the subject. This post provides an overview of inventory turnover and what makes it an important metric.
What Is an Inventory Turnover Ratio?
The inventory turnover ratio (ITR) is an operating performance ratio that measures how many times a business’s inventory is turned over in a given period (usually a year, but it may also be expressed in days). In short, the ITR indicates how well a business’s inventory matches its sales volume. A higher ratio corresponds to a higher frequency of inventory turnover. And inventory churn means you are selling, which means you are generating gross profit.
How to Calculate Your Inventory Turnover Ratio
The formula for determining your ITR is simple. In the equation below, note that “cost of sales” and “cost of goods sold” (COGS) are interchangeable.
Cost of sales/Inventory
Here’s an example:
$60,000/$12,000 = 5
In this case, your inventory turnover ratio is 5, which means that you turn your inventory over 5 times a year. If you want to know how many days it takes, simply divide 365 by your ratio:
365/5 = 73 days
Therefore, you are selling and replacing your inventory once every 73 days.
What Inventory Turnover Ratio Tells You
Inventory turnover ratios differ from industry to industry, so if you’re comparing, make sure it’s an apples-to-apples comparison. Stores with more specialized or costlier products will generally have a lower ratio. For example, a bakery would have a much higher turnover ratio than, say, a car dealership.
A high or above-average ratio usually means that your business has a good balance between inventory and sales volume. As a result, it’s unlikely that you’ll be caught with unsold inventory in the event of a downturn or a drop in demand for your products. However, if your ratio is too high, you might have issues with lost sales due to shortages.
A low ratio could mean that you have a large backlog of unsalable inventory. If this is the case, you may have to consider marking down products to get sales out the door. Likewise, a low ratio could mean that you have too much inventory, or perhaps even that you have overstated the value of your stock (i.e., the higher denominator in the equation would yield a lower ratio).
Why Inventory Turnover Is Good
A high inventory turnover presents several advantages:
Reduced holding costs: If you’re ripping through inventory, then you’re limiting your holding costs, i.e., insurance, rent, utilities, and other associated expenses.
Supplier bargaining power: High inventory churn means that your suppliers are also benefitting from higher sales. Try leveraging this situation to negotiate lower wholesale orders or price drops for bulk orders.
Flexibility: If your inventory churns quickly, you will be better positioned to respond to shifting trends and customer preferences.
Now that you have a handle on the inventory turnover ratio, dig a little deeper into your numbers to gain insights and explore areas for improvement. For example, you might be holding your inventory for too long, or your IRT might be out of line with your industry average.
Need help managing inventory? Sekure’s range of hardware and software solutions—including Payanywhere’s business management tools—can help you run your business seamlessly and manage inventory across channels. Drop us a line today and see how we can help.