Sometimes, your products fly off the shelves, and you can’t seem to restock soon enough. Other times, they sit there gathering dust, and you have to discount to the point where you’re barely breaking even. Generally, as a business owner, you have to keep track of how the products are moving. This is where the inventory turnover ratio comes in.
To answer the question “What is a good inventory turnover ratio?” several factors must be considered, including the size of the business and the type of industry. Ideally, the products should sell fast enough but not so quickly that you have to restock too often. This guide will cover all your inquiries and answers that you need to know about calculating your inventory turnover ratio and how you can optimize it.
What is Inventory Turnover Ratio?
The inventory turnover ratio is a key financial metric that shows the number of times a business bought and sold inventory in a particular period. In addition, the ratio can be used to estimate the amount of time it will take to clear the stock available on hand.
The inventory turnover ratio varies by product category and industry type. Big businesses usually have several inventory turnovers in a given period, but it’s easy to calculate for small businesses because it involves a few product types.
How to Calculate Inventory Turnover Ratio
There are three simple steps involved in calculating the inventory turnover ratio.
- Find the cost of goods sold (COGS): This is the total cost incurred by the company in producing the goods being sold. To find the COGS, you sum up the starting inventory and the net inventory purchases and subtract the ending inventory.
- Determine the average inventory on hand: This involves dividing the sum of the inventory at the beginning and the ending of a given accounting period by two.
- Divide the COGS by the Average Inventory
The inventory ratio formula can be expressed as follows:
Inventory Turnover Ratio = COGS/Average Inventory
High Vs. Low Inventory Turnover Ratio
Businesses tend to favor a high inventory turnover ratio, which implies the business is doing well and reaching its targets. When there is a high turnover ratio, the amount of capital tied up in inventory is reduced, and the business has increased liquidity and financial strength. A high turnover ratio could result from the increased popularity of the products or a significant competitive advantage such as lower prices.
A low inventory turnover ratio is a sign of a weak sales performance or a decline in the product’s popularity. It means the sales targets are not being met, which could result in the business losing money.
So, what is a good inventory turnover ratio? A high inventory turnover ratio is good for a business, but the ratio should not be extremely high, as this means the business could be missing out on potential sales when the stock is sold out.
The Importance of Inventory Turnover Ratio
Why should small businesses calculate their inventory turnover ratio? This figure is a crucial metric that helps to analyze business efficiency. Some of the major advantages of calculating and monitoring inventory turnover ratios are as follows:
- The ratio shows the effectiveness of the business in selling its inventory
- It’s a great metric that business owners can use to compare their performance with other businesses in the same industry
- It highlights the issues in inventory tracking and control that need solving
- It enables the business owners to identify the products that aren’t doing well and need to be discontinued
What is Considered a Good Inventory Turnover Ratio?
Having figured out the importance of inventory turnover ratio and how to calculate it, what is a good inventory turnover ratio? Ideally, a good inventory turnover ratio is somewhere between 4 and 6, but this figure differs depending on the industry and the business size. With an inventory turnover ratio within this range, a business can comfortably meet customer demand without stocking in excess.
For businesses selling perishable goods, like florists and grocers, the ideal inventory turnover ratio is higher to prevent inventory loss due to spoilage.
Ways to Optimize Your Inventory Turnover Ratio
If your inventory turnover is lower than it should be, there are several measures you can take to optimize it.
1. Improve Your Supply Chain
Price should not be the only consideration to make when choosing suppliers. Sometimes, the suppliers with the lowest prices are not the best choice. For instance, if you have a product that has seen a surge in demand, faster delivery times and reliability will be more essential than price.
It’s important to streamline the supply chain and eradicate inefficiencies that drive up your COGS. This way, your sales, profits, and margins will see an overall increase.
2. Change Your Pricing Strategy
You can also adjust your pricing strategy accordingly to move inventory. For items in high demand, you can change the prices to realize larger margins. If you have obsolete inventory, you can lower the prices to free capital. If lowering the prices does not work for the dead stock, you can donate the stock to charity and take a tax deduction.
3. Work on Your Forecast
Inventory forecasting is based on the hard data provided by sales numbers and inventory reports. The more accurate the data, the easier future sales planning becomes. Based on the information gathered, you can make changes and come up with creative ways to move products faster and realize higher profits.
4. Automate Your Purchase Orders
Automation is about increasing efficiency and cutting down costs. You can implement automation by working with an order system that reorders inventory that sells well so that you always have it in stock. This way, you do not miss out on potential sales. Using automatically generated purchase orders results in better control and fewer errors.
5. Implement an Inventory Management System
Your inventory turnover rate is as good as the management system you have in place. It’s difficult to optimize something when you don’t have the proper tools to measure it. It is efficient to have an inventory management system that tracks sales and inventory levels and generates reports in real-time. This helps streamline inventory management and allows you to oversee other aspects of the business without manual processing.
6. Make Use of Effective Marketing and Advertising
How you market and advertise your products also greatly impacts your inventory turnover rates. When you have a proper marketing plan in place, you can focus on items that aren’t moving too well and implement strategies to help sell them better.
A multi-channel approach to marketing helps grow your business and attract new customers, ultimately improving sales and inventory turnover rates.
7. Improve Cash Flow and Inventory Replenishment
You should also look into your ordering cycle, which should be simple when you have accurate historical data. Sometimes, the problem with your turnover rate is overstocking, under-ordering, or both. Overstocking hurts your cash flow and under-ordering results in a loss. Using automated tools that reorder your inventory based on sales data helps improve your cash flow and inventory replenishment.
