The number of times a business sells and replaces its stock over a given time period is its inventory turnover ratio. The inventory turnover ratio, also sometimes called stock turns or inventory turns, helps retailers monitor and manage inventory. The inventory turnover ratio can direct timing and size of reorders, identify slow-selling products to mark down for quick sale and inform individual item purchasing decisions. Here’s how to calculate it and interpret the results.
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Uses for Inventory Turnover Ratio
Inventory turnover ratio is an important tool for two main tasks of inventory management. It helps retailers avoid being either out of stock on popular items or having too many items sitting unsold on shelves. Being out of stock on an item when a customer is looking for it means a retailer has missed out on a sale. Being overstocked means the retailer is tying up money used to purchase inventory on slow-moving items. Overstocks also cost retailers money by occupying warehouse space. In addition to guiding business managers, inventory turn ratios may be scrutinized by lenders when a business uses inventory as collateral for a loan.
A higher inventory number means stock is selling faster and spending less time in storage or on store shelves. That means the business is spending less on holding costs. Lower inventory turns mean stock is moving more slowly. That’s not necessarily bad, since it means customers are less likely to find the items they want aren’t available.
Rather than trying to make inventory turns higher or lower, retailers generally seek to strike a happy medium. Different types of retailers have different benchmarks for efficient inventory turns. A startup, for example, might expect – at least initially – a lower inventory turnover as it introduces a new product.
An annual inventory turn ratio of 2 to 4 is typically considered good for many retailers. This means the retailer is selling off and replacing its inventory from two to four times a year. Retailers manage inventory turnover ratio by buying more or less inventory, using price discounts on slow-moving merchandise, initiating marketing promotions and other means.
How to Calculate Inventory Turnover Ratio
There is more than one way to calculate inventory turnover ratio. The simplest is to divide the total sales during a period by the average inventory during the period. Retailers generally calculate inventory turns on at least an annual basis if not more frequently. Here’s how to do the inventory turnover ratio calculation:
Next, calculate average inventory. To do this, obtain the dollar value of inventory at the beginning of the period and at the end of the period. Add the two figures together and divide by two.
Now to calculate inventory turnover ratio divide the sales figure by the average inventory. Here is how the formula looks:
Inventory turnover ratio = Sales / Average inventory
For example, consider a picture framing shop that sold $200,000 worth of picture frames during the year. At the beginning of the year, it had $45,000 in inventory. At the end of the year, it had $55,000 inventory.
To calculate average inventory, add the $45,000 beginning inventory to the $55,000 ending inventory. This produces a figure of $100,000. Dividing by two gives $50,000 as the average inventory.
Now applying the inventory turnover ratio, divide annual sales of $200,000 by the average inventory of $50,000 to get 4. Here’s how the formula looks for this example:
$200,000 sales / $50,000 average inventory = 4 inventory turnover ratio
An inventory turnover ratio of 4 is within the desirable range for many retailers. It suggests the business is neither buying too much inventory nor risking being out of stock too often. Retailers often do inventory turnover ratio calculations on individual product lines or items to help identify fast-selling products.
Keep in mind that reasonable inventory turnover ratios vary by industry.
Inventory turnover ratio is a basic metric used to help retailers and other businesses manage inventory. It’s also useful for anyone looking to invest in or buy a business. It tells a store how frequently it is going through its inventory and can help avoid overstock and out-of-stock situations. A lower number indicates a store is going through its inventory faster and may need to reorder more frequently. A higher number suggests stock is moving more slowly and the store may be able to reduce its investment in inventory.
Tips on Evaluating a Business
- If you are using inventory turnover ratio to manage or evaluate a business, consider consulting with an experienced financial advisor. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Along with inventory turnover ratio, another good metric to analyze a business’s performance is the cash flow statement. It’s a snapshot of how well a business is managing its cash flow during an accounting period.
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