To ensure your small business is operating efficiently, effectively managing inventory and meeting customers’ needs, you should aim to improve inventory turnover. This, in turn, will help optimise business cash flow and maximise profits.
So, let's dive into the specifics of inventory turnover: What it is, how to calculate it, and what you can do to improve yours.
What is inventory turnover?
Inventory turnover is the number of times a business sells and replaces inventory within a specified timeframe, and understanding it is an important aspect of the stocktaking process. The inventory turnover ratio is used to determine the effectiveness of inventory control and how long a business takes to sell its on-hand inventory stock.
How to calculate inventory turnover ratio
The inventory turnover ratio describes the relationship between the inventory a company holds, and the sales of the inventory (or the ‘turning over’ of the inventory), within a given time period.
The formula which denotes this is as follows:
Cost of Goods Sold / Average Inventory = Inventory Turnover Ratio
However, before doing this, you must first choose the timeframe to be measured, weekly, monthly or if necessary, in daily cycles. The ratio is then calculated dividing sales by the average inventory for this period. Let us look at how the average inventory can be calculated.
It can be done in the following three ways:
- By calculating the average of the daily inventory values for a year
- By averaging the month-end inventory values for 12 months
- By taking the year-end value of inventory
The reason average inventory is used to calculate the ratio is to smooth the variables of any demand peaks and troughs of seasonality or you may only make stock purchase once or twice a year, selling throughout the year. An average inventory will accommodate for both situations.
There are a few aspects of the ratio and its application which need to be considered. It’s better to use the Cost of Goods Sold for the numerator of the equation, rather than actual sales, as sale prices can fluctuate and do not represent how much the company actually spent to manufacture or acquire the goods.
The inventory turnover ratio is essential for assessing the health of your business and predicting cash flow.Alternative inventory turnover ratio formulas
Additionally, you may use one of the following formulas to calculate inventory turnover:
- Day Sales Inventory
- Cost of Goods Sold
Let's do a quick recap of how these metrics work.
Day Sales Inventory
Day sales inventory (DSI) gives an indication about the timeframe in which a company can sell their entire inventory.
The following equation denotes how to do this:
Days Sales Inventory = (Average Inventory ÷ Cost of Goods Sold) x 365
To understand what the calculated DSI means for the company, it is vital to compare it to equivalent companies, as the DSI can change significantly between different industries.
For example, a supermarket or store that sells perishable goods with a short shelf-life should have a relatively low DSI. Meanwhile a company which sells big-ticket non-perishable products may have a much larger DSI.
When we say that the inventory turnover ratio – and more specifically the DSI – are good indicators of a company’s financial position, it is meant that they represent the assets the company has which can quickly be turned into cash.
This is especially important for investors with a concern for their investment, or if the company needs to raise debt. Any assets or inventory the company owns which cannot be sold (in a timely manner) are essentially worthless, and therefore equate to lost investments to the investor, and won’t inspire confidence with banks either.
Cost of Goods Sold
Alternately, the ratio can be calculated using the cost of goods sold (COGS).
Generally seen as a more accurate measure of profitability because in addition to purchase price, it includes any carrying cost of goods sold such as conversion costs, overheads and any labour costs accrued within the defined period.
The COGS are subtracted from sales revenue to ascertain the businesses gross margins:
(Beginning Inventory + Inventory Purchases) – End Inventory
Under the perpetual accounting system, cost of goods sold is determined when a sale is made. In the periodic accounting system, cost of goods sold is not determined until the end of the accounting cycle.
Improving inventory turnover through proper inventory control can reduce the COGS, resulting in increased gross profits and more cash in the bank. Effectively providing SMEs with greater working capital because of the revenue generated by the inventory that is turning over at a regular rate.
Calculating your Cost of Goods sold and Day Sales Inventory are also effective ways of assessing inventory turnover.Different types of turnover ratio
While a lower inventory turnover ratio may point to a lack of sales or excess inventory, a high inventory turnover ratio generally indicates a healthier level of sales or a healthy level of inventory.
The former may predict poor liquidity, overstocking or obsolete stock, while the latter can mean better liquidity, but may also signal inadequate inventory.
What does a high inventory turnover indicate?
The quicker your inventory turnover the lower the risk of deterioration, particularly in the case of perishable products or items with a higher risk of obsolescence.
High turnover is often interpreted as an indicator of strong sales, suggesting greater profitability and return on investment. While this is certainly true in many cases, other factors can contribute to a high turnover and need to be understood.
A high inventory turnover could represent a failure to adequately manage purchasing which in turn, leads to large discounts being offered. Clearing stock to reduce inventory and to free-up capital means nothing if sales are not making a profit.
In fact, with purchase price, handling costs and freight charges this could have a negative impact on revenue streams.
What does a low inventory turnover indicate?
Low inventory turnover suggests a business is holding more goods than they realistically need at any given time. It can result from weak sales, which may be due to pricing or quality issues. Either way, low turnover represents capital tied-up in inventory and may indicate poor inventory management.
The only time when low turnovers are of less concern is when dealing in premium products that produce very high profit margins on finished goods.
The bottom line
Calculating your inventory turnover ratio is only part of the equation. Tracking turnover ratios over time will enable you to see if they are going up or remaining the same.
Take time to analyze what the ratio is really telling you. Fluctuations can be the result of seasonal high demand, economic instability or any disaster that impacts customer-purchasing habits.
Understanding why swings occur will help to identify actions needed to improve profitability and return on investment.
Smart business owners always keep one eye on inventory turnover and use it to help predict customer demand.How to improve inventory turnover: 6 smart approaches
Once you have determined your inventory turnover ratio your next step is to look at ways inventory turns can be improved. There are several areas where efficiencies can be made:
1. Better forecasting
The better you are at forecasting what customers will want and when they will want it, the fewer goods you need to keep in stock and the higher your inventory turnover rate.
Put systems in place that will gather real information about what sells. Small business inventory software will collect sales information and can help to analyse past sales data to determine seasonal trends and provide better forecasting of future demand.
In addition to using historic sales data, you should also undertake market research activities. Talk to your customers to gather informal information about their preferences and talk with sales staff to understand how customers interact with the items on your shelves.
If you are purchasing what your customers want, your inventory will turn over regularly, because your stock will sell, rather than sit on your shelves.
2. Sales and marketing
One way to improve your inventory turnover ratio is by increasing sales. This can be achieved through the formulation of smart marketing strategies that increase demand for your products and drive sales.
A targeted, well-designed and cost-appropriate marketing campaign should result in increased sales and inventory turnover. Marketing campaigns could focus on advertisements or promotional events and special offers and should be monitored and measured to ensure a successful return on investment.
3. Procurement
Purchasing needs to be in line with demand. Using Pareto 80:20 principle, invest mainly in the 20 percent of products that reap 80 percent of the profit. Eliminate products with lower turnover ratios to improve the company’s overall inventory turnover.
Talk with your vendors to regularly review purchase prices and ask for discounts or price reduction when they are quoting for your inventory stock. This way you can reduce the cost of your inventory.
Explore any options available to minimise cost, options such as pre-paid shipping, extended credit and the inclusion of complimentary marketing materials for products.
4. Eliminate old stock
With a greater focus on improved forecasting techniques, you can reduce the need to invest in safety stock. Cut holding costs by disposing of old inventory stock through sales and mark-downs and invest the money in high turnover, faster-moving products.
Adopt a lean inventory strategy. With lower levels of on-hand stock you will turn over inventory more frequently. However, for this strategy to work, you will need to have a strong supply chain that can get items to you quickly to avoid the risk of running out.
5. Resell excess inventory
If after offering discounts on excess inventory you still find that your turnover ratio is low, consider reselling your excess goods back to your supplier at a discounted rate.
Some suppliers will be happy to rebuy the items from you if they can do so at a discounted rate and sell on to other retailers later. This will help to alleviate the burden of excess stock and improve your inventory turnover rate in general.
6. Diversify product lines
Customers like a variety of options so offering new products or services can improve inventory turnover by creating a sense of urgency for customers to make an immediate purchase.
Purchasing these new items or new services helps keep customers interested in your business while potentially fulfilling another need they may have. Remembering to only stock products that sell quickly.
This article was updated in July 2023 to reflect new information, current trends, and adjusted statistics.
