Don’t be alarmed if the phrase inventory turnover or stock turnover makes you want to scratch your head in confusion. After all, most small business owners don’t have formal inventory or accounting training.
But this is one of those times where diving into the more mechanical side could prove to be immensely beneficial and profitable for your business. Let’s take a closer look at inventory turnover together — what it means, what it does, and how to use it.
What is Inventory Turnover Ratio?
Simply put, inventory turnover ratio calculates the number of times that a company cycles through (or replaces) its inventory in any given period such as monthly, quarterly, or annually.
Measuring how fast a business, particularly a retail business, goes through the products it has in stock can reveal many key performance indicators that may otherwise go unnoticed. Some of the areas directly affected by inventory turnover include, but are not limited to:
- Cost management
- Storing and moving supplies
- Account receivable
- Cash flow management
- Profit margin
- Income statement
- Balance sheet
This extensive list makes it easy to see that ultimately, inventory is at the core of a retail operation.
While cash flow is often said to be the lifeblood of a business, and if that’s true, then inventory is most certainly the heartbeat — responsible for generating both the cash flow and profit.
The Basics of Inventory Management
Since inventory levels are such an important part of your business, learning how to manage it is going to be a critical factor in the success of your business. Before you can properly manage your inventory, you first have to understand the role it plays in key areas of your business.
A Financial Perspective
From a financial standpoint, inventory is reported as a current asset on your business’ balance sheet. Current assets are essentially liquid assets such as cash, or other resources like inventory and accounts receivable that are expected to turn into cash within one year of your operating cycle or the one year anniversary of the date on your balance sheet.
Because inventory usually represents a substantial percentage of a company’s assets, the way it moves into, through, and out of the business can predict how the company will do in the long run.
An Operational Perspective
From an operational standpoint, inventory is often thought of as something that is completed by setting aside a large block of time to conduct a physical inventory count. While a physical inventory count is an integral part of determining what is and isn’t on your shelves, most retailers only do a physical inventory count on an annual or semi-annual basis. Although necessary, also time-consuming, it’s not something you have time for as part of your daily routine.
The easiest and most accurate way to track inventory day-to-day is using a Point of Sale system (POS) like ShopKeep. With a POS system, you can monitor the quantity of inventory on hand, set reorder triggers to let you know when it’s time to submit another purchase order to your vendor, and track your Cost of Goods Sold (COGS) – a critical factor in determining your inventory turnover ratio.
Whether you’re a new business just starting out or an established business looking to gain control of your inventory, here are a few steps you can take to start off on the right path.
- Take a physical inventory count. We know it’s a necessary evil and not something any retailer looks forward to, but it has to be done. Since you can’t sell what you don’t have, knowing precisely what you have in stock is the first step of proper inventory management.
- Pull stock reports. If you already have a POS system in place to track inventory, pulling reports is as easy as logging into the back office and generating some reports with a few clicks. If you don’t have a POS system and you’re tracking inventory manually, start gathering your paper reports or Excel documents.
- Compare. Now that you have these two data points, compare the physical count with the data from your stock reports and analyze any discrepancies between the two.
Once you have the final results, make adjustments to the stock item list to reflect the current and accurate totals.
Calculating Inventory Turnover Ratio
Now that you have an accurate starting point, we can talk about how to calculate inventory turnover moving forward.
It all starts with an inventory ratio formula. For all those that disliked algebra in high school, we apologize in advance because we’re about to revisit math class. On a positive note, you finally found a real-world use for it, yay!
Although you can calculate inventory turnover for any given time frame, most retailers calculate it annually. Therefore, the time period we’re going to use in our examples below will be one year.
Cogs Divided by Average Inventory Value
The most accurate way to find your inventory turnover ratio is to take your total cost of goods sold and divide by your average inventory value (COGS / Average Inventory Value = Inventory Turnover Ratio).
Like we mentioned before, you can easily find your COGS using a sales report from your POS system. Your POS system should also have an inventory value report so that you can quickly find your average inventory value.
If the average value isn’t recorded on its own, you can simply take your beginning inventory value for the given period, add the ending inventory value, and divide by two (beginning inventory value + ending inventory value) / 2. By using the average value, you account for any seasonality effects that may skew the ratio.
Using these formulas, let’s say that your COGS for the year was $500,000 and your average inventory value was $100,000 for the same time frame. So, $500,000 / $100,000 = 5. Therefore, over the course of one year, you turn inventory over five times, or 5:1.
Sales Divided by Average Inventory Value
If you don’t have a POS system and cannot easily find your COGS, another way you can find your approximate inventory turnover rate is to take your total sales and divide by your average inventory value.
Let’s say your total sales for the year were $900,000, and your average inventory value was still the same $100,000 we had in the previous example. Using the same formula, $900,000 / $100,000 = 9. Therefore, according to this method, over the course of one year, you turn inventory over nine times, or 9:1.
The downfall to using sales totals to find your inventory turnover rate is that sales include a markup cost, thus inflating the inventory turnover rate. In the two examples provided, the ratio almost doubled when we used the sales totals compared to using the cost of goods sold.
If you’re looking for a quick and dirty method, you can use your sales totals to determine company inventory. Keeping in mind that the results will be slightly inflated.
Days Sales of Inventory (DSI)
Another formula you can add to your arsenal to gauge inventory turnover is the Days Sales of Inventory (DSI). Sometimes referred to as Days Inventory Outstanding (DIO) or Days In Inventory (DII), it helps you measure the average length of time your cash is tied up in inventory and also puts inventory turnover into daily context.
To find your days measurement, you’re going to take your year-end inventory value, divide by your COGS, and then multiply by 365 for the number of days in a year (Inventory Value / COGS) x 365 = DSI.
For example, let’s say your end-of-year inventory value is $80,000 and your COGS is still the same $500,000 we’ve used in the previous examples. If you plug those numbers into the DSI formula, (80,000 / 100,000)365 = 58.4. That means every 58.4 days your inventory will turn and cash is tied up in inventory for a little less than two months.
One thing to note is that regardless of how you choose to calculate inventory turnover, the important thing is to remain consistent to ensure you’re comparing apples to apples.
Which is Better: High Inventory Turnover Ratio or Low Inventory Turnover Ratio?
Now that you know how to calculate inventory turnover a few different ways, you need to put those numbers into context, or it’s not going to provide you with any value.
So, is it better to have high or low inventory turnover? Generally speaking, a higher inventory turnover ratio indicates high sales, products are in high demand, and that you’re moving inventory in a rather efficient manner. On the other hand, a low inventory turnover ratio indicates a low demand for products and weak sales. Therefore, causing them to sit on the shelves longer and tie up your cash.
One thing to keep in mind while trying to determine if the inventory turnover ratio is high or low is industry benchmarks. Benchmarks are standards or references that help you evaluate your business performance against other businesses in the same industry.
Ergo, if you’re a retailer, you should only compare your turnover ratio to other retailers in the same industry and against your industry benchmark.
To give you an idea of where retailers stand, according to CSI Market, the average inventory turnover ratio for apparel retailers is 3.74 times in a 12 month period.
Generally speaking, industries that have a low gross margin such as grocery stores, typically have a higher inventory churn rate than industries with a higher gross margin such as specialty or high-end retailers like jewelers. The reason for this is because a company with a low margin needs to sell a lot more goods than a company with higher margins to make the same amount of profit.
The productivity of your inventory (as measured by the ratio of inventory turnover) will determine your company’s flexibility and overall pace in generating profit. Drive your business towards the next level of growth in the coming year by finding ways to make adjustments to your inventory turnover and to push the envelope of cash flow and profitability.