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Inventory Turnover Ratio: What It Is, How It Works, and Formula

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It is important to understand the concept of stock turnover ratio as it assesses the efficiency of a company in managing its merchandise. A higher value of the stock turnover ratio indicates that the company can sell the stock inventory relatively quickly. A lower value means the company holds a higher inventory value at any time. To draw meaningful insights, it is advisable to compare the stock turnover ratio for companies in the same industry and preferably of comparable sizes. A higher turnover ratio means that a company is selling more and replacing its inventory faster.

In some cases, however, high inventory turnover can be a sign of inadequate inventory that is costing the company sales. Suppose we’re tasked with calculating the stock turnover ratio for a consumer retail company using the following financial assumptions. Many companies get so caught up in increasing revenue that they compromise profits.

  1. Companies must account for these seasonal variations in demand to maintain an appropriate ITR.
  2. Inventory turnover is a financial ratio showing how many times a company turned over its inventory relative to its cost of goods sold (COGS) in a given period.
  3. The days inventory outstanding (DIO) metric measures the amount of time required by a company to sell off its inventory in its entirety.

Retailers that turn inventory into sales faster tend to outperform comparable competitors. The longer an inventory item remains in stock, the higher its holding cost, and the lower the likelihood that customers will return to shop. Since the cost of goods sold (COGS) was provided, the next step is to divide the COGS incurred each period by the average inventory balance.

Since the inventory turnover ratio represents the number of times that a company clears out its entire inventory balance across a defined period, higher turnover ratios are preferred. Inventory turnover is a simple equation that takes the COGS and divides it by the average inventory value. This ratio tells you a lot about the company’s efficiency and how it manages its inventory. Companies should look for a higher inventory turnover ratio that balances having enough inventory in stock while replenishing it often. Depending on the industry that the company operates in, inventory can help determine its liquidity. For example, inventory is one of the biggest assets that retailers report.

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The way in which this is usually calculated is by using the inventory turnover ratio. This article will explore the uses of the inventory turnover ratio, by looking at the factors that affect it and how to implement the ratio calculation. Inventory turnover ratios play a significant role in financial modeling as they provide insights into a company’s inventory management efficiency and can impact various financial metrics and projections. They provide critical inputs for projecting financial statements, evaluating business performance over specific accounting periods, and making informed decisions regarding inventory management strategies. A lower inventory turnover ratio may suggest several issues, such as slow sales, excess retail inventory, poor demand forecasting, ineffective purchasing, or inefficient supply chain management.

As a business owner, analyzing it can provide valuable insights that help you improve related processes. A high inventory turnover ratio indicates that a company is efficiently managing its inventory, which can lead to lower holding costs and potentially higher profits. On the other hand, a low ratio suggests that a company may be overstocked, which can lead to higher holding costs and potentially obsolete inventory.

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STR tells you if you have over-invested in stock and indicates if you have the right inventory mix. It directly relates your inventory level to the demand level for that inventory. Whether it’s running sales, bundling products, flexible budget report or investing in digital marketing campaigns, selling more inventory more quickly can help you improve your inventory turns. Your industry association may have information about industry average turnover ratios.

How To Calculate Inventory Turnover Ratio For Your Business

It is the ratio defining how many times the inventory was sold and replaced in a given period of time. For a trading concern, an inventory/material turnover ratio of 6 times a year is not very high. One would expect a trading company to have a faster rate of stock turnover. However, if a company exhibits an abnormally high inventory turnover ratio, it could also be a sign that management is ordering inadequate inventory, rather than managing inventory effectively. That said, low turnover ratios suggest lackluster demand from customers and the build-up of excess inventory. Thus, the inventory turnover rate determines how long it takes for a company to sell its entire inventory, creating the need to place more orders.

Another ratio inverse to inventory turnover is days sales of inventory (DSI), marking the average number of days it takes to turn inventory into sales. DSI is calculated as average value of inventory divided by cost of sales or COGS, and multiplied by 365. The inventory-to-saIes ratio is the inverse of the inventory turnover ratio, with the additional distinction that it compares inventories with net sales rather than the cost of sales. Because an income statement line item is being compared to a balance sheet item, there is a mismatch created between the time period covered by the numerator and denominator. Optimizing your inventory turnover ratio requires a multi-pronged approach, but don’t overextend yourself.

Also, a company might have an ultra-high ITR while going bankrupt because the company isn’t making enough profit on each sale. Although it’s usually not a good idea to sacrifice profit for turnover, it’s sometimes necessary—for example, when it’s more costly to store “dead stock” in your warehouse than sell it off quickly. Efficient inventory management also reduces the risk of holding products that might become obsolete or spoil, especially in industries like tech or perishable goods.

If the time for a single SKU to turn over is too long, then it’s draining your resources, even if it eventually sells. Over time, though, you’ll want to move past industry averages to maximize your company’s profits. Sorry, there’s no silver bullet for this — you need to dive into your data and income statements to find out what’s best for your profitability and growth. If you’re continually restocking inventory right as you’re running out of it, your inventory levels could get dangerously low.

While COGS is pulled from the income statement, the inventory balance comes from the balance sheet. Perhaps the most common use of a turnover ratio is to measure the proportion of a company’s employees who are replaced during a year. Share turnover should not be confused with the turnover rate of a mutual fund or an exchange traded fund (ETF), which measures how actively managed the portfolio is. In addition, it may show that Walmart is not overspending on inventory purchases and is not incurring high storage and holding costs compared to Target. Secondly, average value of inventory is used to offset seasonality effects. It is calculated by adding the value of inventory at the end of a period to the value of inventory at the end of the prior period and dividing the sum by 2.

Because the inventory turnover ratio uses cost of sales or COGS in its numerator, the result depends crucially on the company’s cost accounting policies and is sensitive to changes in costs. For example, a cost pool allocation to inventory might be recorded as an expense in future periods, affecting the average value of inventory used in the inventory turnover ratio’s denominator. By increasing the number of units you sell, you can significantly improve your inventory turnover ratio, even without adjusting your inventory levels. You can achieve this in many ways, including expanding your sales team, updating your marketing strategy, and exploring new sales channels. The inventory turnover ratio is a financial metric that reflects the efficiency of your inventory management.

Let us take the example of a company to demonstrate the stock turnover ratio concept. During 2018, the company incurred a raw material cost of $150 million, a direct labor cost of $120 million, and a manufacturing overhead cost of $30 million. The inventory holding at the beginning of the year and at the end of the year stood at $300 million and $320 million, respectively. Calculate the stock turnover ratio of the company based on the given information. Simply put, the inventory turnover ratio measures the efficiency at which a company can convert its inventory purchases into revenue.

A company’s inventory turnover ratio reveals the number of times a company turned over its inventory relative to its COGS in a given time period. This ratio is useful to a business in guiding its decisions regarding pricing, manufacturing, marketing, and purchasing. The calculation of the stock turnover ratio consists of dividing the cost of goods sold (COGS) incurred by the average inventory balance for the corresponding period. That means your business sells and replaces its inventory five times per year.

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