The inventory turnover ratio is the number of times a business sells and replaces inventory within a specified period. In effect, the inventory turnover ratio determines how long a company takes to sell its on-hand inventory and helps a business determine how well they are performing.
Calculating Inventory Turnover
The first task in establishing your turnover ratio is to choose the timeframe to be measured. This can be based on weekly, monthly or where necessary, daily cycles. The ratio is then calculated dividing sales by the average inventory for this period.
Average inventory is used to calculate the ratio because if reflects any demand peaks or troughs caused by seasonal variability. This simple calculation is achieved by adding the beginning inventory to the end inventory and then dividing by two.
Alternately, the ratio can be calculated using the cost of goods sold (COGS). This is generally seen as a more accurate measure of profitability because in addition to purchase price, it includes any carrying cost of goods sold such conversion costs, overheads and any labor 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.
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.
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.
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.