Inventory Turnover Ratio

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08 min read.

As a business owner, you want to deal in products that move at a decent pace and are popular with the customers. The inventory turnover ratio tells you how fast a company sells a product and how many times it needs to be reordered. It is a measure of how a company can efficiently control its inventory levels.

Formula for inventory turnover ratio

Inventory Turnover ratio = (Cost of Goods Sold)/ ( Average Inventory)

Definition and interpretation of stock turnover ratio

A company’s inventory turnover ratio, also known as the stock turnover ratio, demonstrates how efficiently it converts its inventory into sales. It establishes a relationship between the following elements-

  • Cost of goods sold
  • Average inventory

The result of the stock turnover ratio formula refers to the number of times the company has managed to sell its entire stock in a given year.

A high inventory turnover is not always an indicator of progressive performance levels. It can also be construed as a loss in sales opportunities as a result of inadequate inventory.

On the other hand, overstocking of products and merchandise could lead to a low inventory turnover ratio. Another reason for low inventory turnover ratio is deficiencies in product manufacturing or marketing

Cost of goods sold or revenue cost refers to the direct costs associated with the production of goods or services, including material, labour and overhead costs that are sold. These costs are directly linked with revenue. The purpose of the term “cost of goods sold” is to reflect the true cost of the goods so produced and sold. 

Cost of goods sold = Opening stock + purchases – closing stock

Average Inventory = (Opening stock + Closing stock) / 2

For most companies, their inventory levels fluctuate greatly throughout the year. This is why average inventory is used.

Example- Ben’s Furniture and Fittings sells furniture to corporate offices. They reported the cost of goods sold as Rs. 3,50,000 in their income statement during the current year. The opening stock was Rs. 2,25,000, and the closing stock was Rs. 2,75,000.

Average inventory  = (2,25,000 + 2,75,000) / 2 = Rs. 2,50,000

Inventory turnover ratio= 3,50,000 / 2,50,000 = 1.4 times

This means that Ben’s Furniture and Fittings have sold their entire inventory only once in the entire year.

The optimal inventory turnover ratio varies from industry to industry. Generally, it is important to have a high stock turnover ratio. This shows that the company is buying sufficient inventory levels to convert them into sales quickly and efficiently.

Benefits of knowing inventory turnover ratio and its application

The ratio helps a business in the following ways-

  • Evaluate how efficiently a company can control its merchandise.
  • Overall management of the inventory levels.
  • Facilitates movement of cash flows and thus helps manage the working capital requirements.
  • Keeps a check with the industry standards of inventory turnover ratio.
  • Measures the liquidity of an organisation. If the stock turnover ratio is high, it translates to higher liquidity since the business frequently receives money from its customers.

Tips to improve the inventory turnover ratio for business

  • Product Bundling

Offering two products of complementary nature together to boost sales is an effective technique to move merchandise. Amazon does this best of all. Whenever one places an order, for instance, an order for guitar strings. The bundling option will also show the customer the price for guitar strings + a guitar case would look like. This approach often results in the conversion of inventory into sales.

  • Marketing and promotion advancements

Marketing campaigns, attractive sales campaigns with discounted merchandise is commonly used tactic in the world of sales. More often than not, it is a success. Customers always love a good bargain, and offering them discounts on their favourite products is a win-win for the business and the customer. The customer gets their favourite product; the business gets to clear out their inventory.

  • Pricing adjustments

Regular and timely review of pricing strategies can go a long way towards achieving high levels in sales. Adjusting your prices bearing in mind the market fluctuations helps you have more control over your sales. Premium pricing, seasonal pricing, and cost-plus pricing are some of the pricing techniques employed.

  • Improving inventory replenishment levels

Whenever you hear the sentence “This product is out of stock”, it fills you with a sense of disappointment as a customer. It is essential to ensure that your customers never have to listen to that particular sentence as a business person. This is solved by ensuring that the order levels are replenished quickly and efficiently to not lose out on a potential customer or a potential sale. The ordering cycle has to be quick, efficient and consistent.