What is Inventory Turnover Ratio?

Inventory turnover ratio is a financial parameter which measures how fast the current batch of inventory is removed and converted into sales. In other words, inventory turnover ratio tells us how many times the average inventory is turned into sales during a period. A high inventory turnover ratio means that the product of the company is in high demand and are being sold quickly as soon as they arrive in the market. A high inventory ratio also indicates that the inventory management cost of the company is low and less effort is needed to manage the inventory.  

How the Inventory Turnover Ratio is Calculated?

The Inventory Turnover Ratio is determined using the following formula:

The important thing to note down is that average inventory is used in this formula instead of ending inventory because the inventory of many companies fluctuates greatly throughout the year.

Example 1:

ABC Corp. is in a business of selling car accessories. During the current year it sold total $20,000 of car accessories. Company’s initial inventory was $12000 and the ending inventory was $32000. The inventory turnover ratio of ABC Corp. can be calculated as follows:

Cost of goods sold= $20000

Average inventory= (12000+32000)/2= $22000

= 0.91

It means that ABC Corp. sold approx. 0.91 times of its inventory and approx. 9% of inventory is surplus which will be sold in next year.

Example 2:

Calculate the inventory turnover ratio of the company using following data:

Interpretation of Inventory Turnover Ratio

Inventory turnover ratio is an indicator of how efficiently a company is handling its inventory. Let us discuss the different cases of inventory turnover ratios:

The inventory turnover ratio is high

A high inventory turnover ratio indicates that the company is managing its inventory well and efficiently. The holding cost of inventory is low and the chances of obsolescence are less. It also indicates that the company has healthy cash flow and it is profitable. Many investors take investment decisions regarding a company by looking into the inventory turnover ratio of the company.

The inventory turnover ratio is low

If the inventory turnover ratio is low, it means that the products of the company are not in demand and are not selling frequently. It also indicates that the company has a slow moving inventory and holding cost of the inventory is high. A substantial part of the profit of company is being used to manage the inventory and the company is not cash rich due to this.

Some Measures to Improve Industry Turnover Ratio

If the inventory turnover ratio of your company is low, then you can try the following measures to improve it:

(a) Review the pricing of your product and change your pricing strategy.

(b) Try to increase the sales by adopting new marketing techniques.

(c) Segregate the fast moving inventory and slow moving inventory and make strategy according to the type of inventory.

(d) Understand the needs of the customer and improve your product accordingly to get advance orders form the customer.

Importance of Inventory Turnover Ratio

Inventory turnover ratio is very important parameter for the business. Businesses use this parameter to measure the business performance and cost management. Some of the uses of inventory turnover ratio are as follow:

To compare the performance of a company against Industry standards

Inventory turnover ratio can be used to determine how fast a company is selling its inventory and its efficiency can be compared against industry standards. For most industries, the inventory turnover ratio lies between 5 to 10. However, it varies industry to industry depending on the complexity and business environment of the industry. It also depends upon the nature of the product.

For e.g. industries having low margin, low price, off the shelf products such as retail industries are having high inventory turnover ratio because they sell large volume of products which sells quickly. On the other hand, the industries having high value, high margin products such as airline manufacturing and automobile industry have low inventory turnover ratio. The analysts may use the inventory turnover ratio to determine whether a company is performing well historically as compared to its competitors in the industry and clearing its inventory is less time than other competitors or not! The investment decisions may also be taken based on the inventory turnover ratio. If a company is having high inventory turnover ratio, it means it is selling its inventory fast and hence more profitable and hence it is worth investing in the company.

To measure the liquidity of a company

Another use of the inventory turnover ratio is that it is used to measure the liquidity of a company. A high inventory turnover ratio indicates high liquidity since the inventory of the company are selling quickly and hence the company is having sufficient cash flow and also the cash used in maintaining the inventory is less. Organizations should always strive to maintain the high inventory turnover ratio to keep themselves profitable.

A Crucial Parameter for Companies dealing with Perishable Goods

Businesses dealing with the perishable goods and time-sensitive items should always be cautious about the movement of their inventory. The goods may be milk, vegetables, fruits, eggs, trending or seasonal clothes, etc. Selling these items quickly is very crucial as keeping these goods longer in the shelfs results in losing money for the companies.

Conclusion

Inventory turnover ratio is very important parameter which measures how efficiently a company is handling its inventory. For the companies dealing with perishable goods and time- sensitive items, it is more critical. The companies should make efforts to keep their inventory turnover ratio high so that their stocks should be cleared frequently and they become more profitable. The management should be aware of the standard industry inventory turnover ratio which is different for different industries and try to match their inventory turnover ratio with the industry standards. The inventory turnover ratio for a clothing industry may be between 5 to 8, while for the companies selling automotive parts it may lie somewhere in between 45 to 50.

Also read: Understanding Descriptive Statistics: Mean, Median & Mode