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Your inventory turnover ratio helps you work out how quickly your stock sells by showing how often you’re selling and replacing it. It helps compare different periods to one another, so you can work out when demand is highest and when to expect a quieter season, as well as identifying which are your most popular products. It’s an essential tool in a profit and loss forecast.
How to calculate inventory turnover
Your inventory turnover is typically worked out by dividing the costs of goods sold in a particular period by the average inventory. In this calculation, the average inventory takes into account the cost of the beginning inventory and the cost of the end inventory. Your business’s cost of goods sold can be calculated based on the costs of materials and labor, or by the more straightforward sum of the amount paid to the supplier.
Some businesses will then use this information to work out the day’s inventory, which helps you identify when or how often you need to restock. In the context of a financial year, this figure can be reached by dividing one by your inventory turnover and then multiplying the result by 365.
An example of an inventory turnover formula
Ratios and formulas can look complicated at first glance, but it’s a simple enough equation to work out. For example, if your business had a year-end inventory of $10,000 and an annual cost of sales of $100,000, your inventory formula would look like this:
You could then work out your day’s inventory as follows:
This tells you the number of days in which your stock is likely to be sold. Of course, this is an average based on the figures you have to hand and so cannot provide an exact timeframe or number, but it helps in terms of contingency and future planning as well as sharing information with stakeholders.
What is a good inventory turnover ratio?
Generally speaking, the higher your inventory turnover, the better. This is because a high turnover indicates that you’re selling the stock you bring in quickly, indicating a demand for your product and demonstrating that you’re not wasting money on unsold stock. Of course, a particularly high turnover could indicate that you’re not buying enough stock, or you’re not buying frequently enough, to keep up with your consumer demands, and so you may be missing out on potential sales. It’s important to find the right balance between wasted stock and stock shortages.
How do you find inventory turnover figures for your business?
The calculation mentioned above is a quick and easy way to work out the turnover figures for your business. You’ll often find that this number plays a key role in financial modeling and is often assessed on a yearly or quarterly basis in information made available to company shareholders.
How do you improve your inventory turnover figures?
If you find that your turnover rate is excessively low, there are many ways to address the issue. One obvious technique is to increase the demand for your product to match your supply by improving your marketing strategy. This could mean reaching out to a new customer base or reassessing how you approach your existing audience. It’s also important to review your prices as well as your costs and work out if you’re paying the right amount and charging your customers accordingly.
You can also use your inventory turnover figure to adapt your strategy for the future. If you’re wasting a lot of stock, this represents an opportunity to reduce your spending and limit the amount you’re buying – or to switch your focus to a more profitable product. If you’re missing out on sales, you may want to consider increasing your production.
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