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What’s it: Inventory turnover ratio is a financial ratio to show the number of times companies convert their inventory into sales during a given period. It is useful for evaluating management effectiveness in managing inventory. The higher it is, the faster the company sells inventory and posts revenue.
Inventory management is important because it affects not only profitability. But, it can also impact a company’s liquidity and overall financial health.
Why is the inventory turnover ratio important?
Analyzing inventory turnover ratios helps management make better decisions about their operations, including marketing, pricing, production, and purchasing strategies. Exploring why the numbers go up or down helps companies stay financially healthy and competitive. In addition, companies can ensure their marketing mix stays aligned with market demands.
When a company can deplete inventory quickly and replace it with new ones, it can be better at collecting revenue. And in the other hand, it also reduces costs tied to inventory, such as rental, transportation, warehouse space, and insurance costs. Ultimately, it can positively impact the company’s profitability and financial liquidity.
On the other hand, if a company keeps inventory for too long, costs increase, which in turn, weighs on the company’s profits. It also reduces its liquidity and financial strength as more money is tied up in its inventory.
Then, for some businesses such as retail, storing too long can reduce consumer interest in shopping. When they find the items in the store are old, they are likely to be reluctant to visit the store in the future. Thus, low inventories make old products unsellable because they are damaged, obsolete, or rotting.
Management can change pricing strategies or offer other incentives to increase inventory turnover. Thus, sales can increase, and inventory can run out faster.
Another way is to streamline the supply chain to eliminate inefficiencies along the chain. If successful, goods are available when consumers need them, which also requires more accurate sales and inventory forecasting. In addition, the inputs also immediately arrive at the factory for processing.
How to calculate the inventory turnover ratio?
We need to take the cost of goods sold (COGS) data on the income statement and inventory on the balance sheet (in the current assets section) before calculating the inventory turnover ratio. Having obtained this, we divide COGS by the average inventory for the last two years. The inventory turnover ratio formula is as follows:
- Inventory turnover = COGS / Average inventory
We use inventory averages to avoid bias due to fluctuations in inventory over time.
Take a simple example. A company reports inventories of $3 million in 2021 and $4 million in 2022 on its balance sheet. On the income statement, it posted a cost of goods sold of $5 million in 2022. Applying the above formula, we get an inventory turnover ratio of 1.4 =5/((3+4)/2).
How to read inventory turnover ratio?
A low ratio could be due to weak sales. For example, the marketing strategy adopted may be less effective so that sales do not reach the target. Or, it could also happen due to excess inventory. Therefore, a lower ratio is less favorable because it indicates management is less effective in managing inventory.
Conversely, a higher ratio could indicate strong sales, which is desirable. If it can quickly fill its sold inventory with the new one, it can generate more revenue.
But, indeed, the high ratio can also occur due to insufficient supplies, for example, due to production problems. In fact, the company’s sales grew normally. This situation is, of course, undesirable. And, when market demand grows strongly, insufficient inventory prevents the company from optimizing sales.
Then, to provide deeper insight, analyzing the inventory turnover ratio requires us to compare the numbers we get with the industry averages in which the company operates. For example, suppose the ratio is relatively high compared to the industry average. In that case, it could indicate more effective management than competitors’ averages.
Or it occurs due to insufficient inventory levels. So is the high ratio due to weak sales or too little inventory? We can examine this by comparing the company’s sales growth with the industry’s sales growth to find the cause.
What is the ideal ratio?
The ideal ratio varies between companies, depending on the industry in which they operate. For example, non-durable goods companies such as food require faster turnover. That’s because, if they don’t sell, their goods quickly spoil or rot. So they will usually offer discounts or other incentives to attract more demand to avoid that.
In contrast, inventory turnover of durable goods such as furniture or electronics is usually lower. This is because customers usually need time to make shopping decisions. For example, they will not buy shortly for repeat purchases if the existing goods are still in good condition.
Ratios also vary between low-margin and high-margin industries. Low-margin industries require high turnover to support high revenues due to low unit profit. In contrast, high-margin industries have lower inventory turnover ratios on average.
