The inventory turnover ratio, also known as the stock turnover ratio, is a financial ratio that shows how many times a company turned over its inventory concerning the cost of goods sold in a given time.
A company can divide the days in the period, typically a fiscal year, by the inventory turnover ratio to calculate how many days it takes to sell its inventory, on average.
The inventory turnover ratio can help businesses make better decisions on pricing, manufacturing, marketing, and purchasing. It is one of the most efficient ratios used to measure how effectively a company makes use of its assets.
Let us understand a bit more about the inventory turnover ratio.
Inventory turnover ratio= cost of goods sold/average inventories
Where,
1. Cost of goods sold= is the cost attributed to the production of goods that are sold by the company over some time. The cost of goods sold by the company is reflected on the company’s income statement
2. Average inventory= is the value of inventory throughout a certain period. It is the average of opening inventory added to the closing inventory, divided by 2
The inventory turnover ratio is a great indicator of how the company handles its inventory, if an investor wants to check how well the company is managing its inventory, they should check how much higher or lower the inventory turnover ratio of the company
1. When the inventory turnover ratio is high- the company has been holding its inventory quite well, with less holding costs and fewer chances of obsolescence
2. When the inventory turnover ratio is low- the company’s inventory is very low and the movement of products in the market is slow. There is a lack of sales in the market. As a result of which the company’s inventory is a slow-moving inventory, which leads to higher costs of inventory and fewer profits.
3. To improve its ratio, the company can adopt the following steps Review strategies relating to the pricing of the products
4. try to improve sales by using marketing techniques
5. analyze the fast-moving inventory and slow-moving inventory
6. improve bargain power and review purchase prices regularly
7. understand the needs of the customer and try to get orders from customers in advance.
The inventory turnover ratio has several important benefits which make it a well-sought-out ratio. Some of the benefits of the inventory turnover ratio are as follows:
1. it measures the soundness of the retailer’s inventory methods
2. it also indicates poor inventory planning and a lack of control techniques
3. by improving the inventory turnover ratio, a retailer can increase profitability by carrying fewer inventories
4. The inventory turnover ratio presents meaningful comparisons and informs retailers about the latest trends.
These are some of the important benefits of the inventory turnover ratio which makes it one of the most sought- ratios to determine inventory in a business organization.
The inventory turnover ratio determines the financial health of an organization. Supply, demand, profit, or loss, along with internal functioning, are all factors indicating the future of your company. But a good inventory turnover ratio is essential to determine a brighter financial health of an organization.
However, as per calculation, an inventory turnover ratio between 4 and 6 is usually a sign that the financial health of the enterprise is good.
A higher inventory turnover ratio is a good sign
A higher inventory turnover ratio is a sign that the company is experiencing quick sales and better demand for goods. However, a high inventory turnover ratio, also reflects the loss of sales, because the company has failed in keeping up with the high demands
A lower inventory turnover ratio is a bad sign
It indicates lower sales and decreasing demand for products.
Despite the above two interpretations, the inventory turnover ratio of every company is different, depending on its goals, objectives, and numbers. An ideal inventory turnover ratio depends on the following factors:
1. Size of the organization
2. Cash flow
3. Quick liquidation of assets
4. Products you sell
Inventory turnover measures how efficiently a company uses its inventory by dividing its cost of sales, or cost of goods sold (COGS), by the average value of its inventory for the same period.
Companies will almost always aspire to have a high inventory turnover. After all, high inventory turnover reduces the amount of capital that they have tied up in their inventory. It also helps increase profitability by increasing revenue relative to fixed costs such as store leases, as well as the cost of labor
What counts as a “good” inventory turnover ratio will depend on the benchmark for a given industry
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