If you run a small business, you are probably aware of accounting ratios – but you might not follow them closely. An accounting ratio is essentially a relative comparison of two pieces of financial data. For example, you may be familiar with the ‘quick ratio’ (or the acid test), which subtracts inventory from current assets and divides the result by current liabilities. This essentially acts as a litmus test for solvency – an indicator of how well a firm can meet current debt out of cash and liquid assets. In the inventory management context, asset turnover ratios are useful indicators of how well your business is using its assets to generate sales revenue. The starting point is the inventory turnover ratio – let’s take a look at how the inventory turnover ratio is calculated, and what it can tell you about your inventory utilisation.
How is the inventory turnover ratio calculated?
The inventory turnover ratio represents the number of times inventory is sold or exhausted in a given time period (such as a financial year). The formula for the inventory turnover ratio is often calculated as a ratio of the Cost of Goods Sold and Average Inventory:
Just as valid, however, are several other formulations using different metrics. The key point is that the trend will be the same provided that your business uses the same formula consistently. For example, a simpler method may be to calculate the inventory turnover ratio as follows:
A higher inventory turnover ratio generally indicates quicker, more efficient disposal of inventory. If a business has moved $100,000 of product over a financial year, but has held $20,000 worth of inventory on average, then its inventory turnover ratio will be $100,000/$20,000 = 5. But if that business held $32,000 of inventory on average, it’s inventory turnover ratio will be $100,000/$32,000 = 3.125, reflecting that the business disposed of inventory more slowly over that period.
Why does the inventory turnover ratio matter?
In the examples above, the total sales across the financial year were $100,000 in both scenarios. If the cost of goods sold was the same in either case, why does the inventory turnover matter at all? Essentially, the inventory turnover ratio is an indicator of profitability because it reflects the extent to which capital is tied up in idle inventory. If inventory is sold more slowly, capital is held up in stock that could otherwise be used to generate income elsewhere in the business – incurring an opportunity cost. If a business uses debt to finance some (or even all) of its inventory, having extra inventory waiting in a warehouse incurs interest. The inventory turnover ratio is also related to the inventory carrying costs a business will incur – the lower your business’ inventory turnover ratio, the more you can expect to pay in costs such as handling and warehouse space.
How can a firm increase its inventory turnover ratio?
While increasing demand for your products will lead to a higher inventory turnover ratio, it makes sense to cover off the lowest hanging fruit first. Consider reducing the amount of each product you hold in stock at any one time, or even stock fewer product lines. Other strategies, such as implementing drop shipping or just-in-time inventory, may be appropriate for some product lines and some businesses.