A solid grasp of inventory turnover ratio turns hopeful businesses into proven ones.
It’s not a stretch to say that, for most companies, the movement of inventory through the supply chain is your business. How good your operation is at that is the strongest indicator of future success.
So, how does a company gauge the health of that movement? One way is inventory turnover ratio.
Inventory turnover ratio shows how efficiently a company handles its incoming inventory from suppliers and its outgoing inventory down the supply chain.
What Is Inventory Turnover?
Inventory turnover ratio is a measure that shows how many times a business has sold then replaced their inventory over a set time period.
Looking at the inventory turnover definition, it’s clear that it’s an important metric. It sheds light on how good your business is at selling inventory. And on how many days sales in inventory you've got left.
What Is Stock to Sales Ratio?
Stock to sales ratio is an inventory management metric that shows the relationship between the value of your stocked inventory (from using inventory costing methods) and the value of your sales over a given period of time.
The stock to sales ratio formula is:
Stock to Sales Ratio = Inventory Stock ($) / Sales ($)
It’s similar to the inventory turnover ratio meaning, but it relates inventory to total sales, not COGS. And it’s typically calculated for shorter inventory periods, like weeks or months. Whereas inventory turnover ratio tends to be used for longer time frames, like quarters or years.
How to Calculate Inventory Turnover
Two things allow you to figure out how to calculate inventory turnover ratio. Those are COGS and average inventory. We’ll assume you already have your COGS. If you don’t, here’s how to calculate COGS.
Average the Inventory
Average inventory is the estimation of the value ($) or number (units) or a particular type of inventory at any given time over a set time period. Here’s how to calculate average inventory level:
(Beginning Inventory + Ending Inventory) / 2
All it is is the sum of beginning and ending inventory—from a specific time period—divided by two.
Inventory Turnover Formula
Once you have your COGS and average inventory, the inventory turnover ratio formula is simple:
Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory
Let’s walk through it step-by-step with an inventory turnover equation example.
How to Calculate Inventory Turnover Ratio: Example
To calculate inventory turnover ratio, we need COGS and average inventory. Here’s the step-by-step process. In this example, let's pretend we’re a coffee roasting company calculating inventory turnover ratio for pounds of coffee over a six-month period. Each pound of coffee costs $6.
Step 1: Determine Inventory Levels
Let’s say we have 100 pounds of unroasted green coffee beans at the outset. 100 pounds is our beginning inventory. Throughout the six-month period, we receive 500 pounds of unroasted green coffee beans. 500 pounds is our received inventory. At the end of the six-month period, we count our inventory again and we have 80 pounds of unroasted green coffee beans. 80 pounds is our ending inventory.
Step 2: Calculate COGS
Now that you have the three key numbers we need for COGS, we can calculate it.
Starting inventory = 1000 pounds or $6,000
Received inventory = 900 pounds $5,400
Ending inventory = 800 pounds or $4,800
COGS = $6,000 + $5,400 - $4,800
COGS = Starting Inventory + Received Inventory - Ending Inventory
COGS = $6,600
This number can also be expressed in units to calculate inventory usage rate. This means that, over a period of one month, the cost spent to acquire and produce the bags of coffee that ultimately sold was $6,600.
Step 3: Calculate Inventory Turnover Ratio
Inventory Turnover Rate = $6,600 / Average Inventory
Inventory Turnover Rate = $6,600 / [(Beginning Inventory - Ending Inventory) / 2]
Inventory Turnover Rate = $6,600 / [($6,000 - $4,800) / 2]
Inventory Turnover Rate = $6,600 / $600
Inventory Turnover Rate = 11
Our business sold and replaced its coffee stock 11 times over the inventory period.
Using an Inventory Turnover Calculator
Most businesses calculate inventory turnover ratio using automated inventory management platforms. How to calculate inventory turnover ratio is usually built into that type of software.
If you’re not keen on manually calculating your inventory turnover ratio, you have two options. First, look into the inventory control automation system you use for an inventory turnover ratio calculator. Second, if you don’t have inventory management software, look into getting it. Inventory turnover ratio is one of the most important inventory KPIs. You need to be confident that yours is accurate. Computers do that really well.
What Is a Good Inventory Turnover Ratio?
Common knowledge states that an inventory turnover rate below 5 isn’t very good. And that most high-performing businesses maintain inventory turnover rates of between 5 and 10.
But a “good” inventory turnover ratio, like a "good" inventory shrinkage, varies among industries. Here’s some data from ReadyRatios.com that shows average inventory turnover rate across some of the more significant industries:
This is why it’s important to benchmark your ratio. Because inventory turnover ratios differ between industries, don’t hold yourself to an irrelevant standard. Hold yourself to your own historical numbers. Calculate your inventory turnover ratio regularly and compare it against past results to gauge progress. Chart improvement. Control what you can control. That's all you can do.
What Does High Inventory Turnover Mean?
High inventory turnover indicates that there is a direct and healthy relationship between the amount of inventory you purchase and the amount you sell.
By quickly turning raw materials inventory into finished goods inventory and selling them, you’re minimizing inventory carrying costs. You’re also quickly replenishing cash and putting yourself in a position to react to customer and market demands and trends quickly.
On the other side of the coin, low inventory turnover signals poor purchasing or sales and marketing strategies. Excess inventory inflates carrying costs—and balance sheets take a hit because of all the cash tied up in sitting inventory.
How to Optimize Inventory Turnover Ratio
Here are some tips for improving your inventory turnover rate and buffing up your balance sheet:
- Invest in marketing. Any increase in visibility, demand, and sales boosts turnover. Assuming you don’t follow that increase up with bigger purchase orders.
- Make a habit of reviewing your pricing strategy. There’s a fine line between ideal margin and volume. If you can get there, you’ll increase demand and revenue together.
- Embrace inventory management. Poor turnover isn’t all supply- or demand-based, as some businesses assume. Often it’s a matter of sharpening up your inventory management strategy and making sure your production process is able to withstand supply and demand.
- Ditching products that don’t sell. Don’t tax your manufacturing process and storage costs with goods that have low turnover ratios. Focus on the items with demand.
- Automate your inventory control. Demand forecasting is one particularly helpful functionality in this regard. Inventory management software is out there, waiting to make your life easier and your inventory turnover ratio higher.
- Optimize your sell through rate. Sell through is similar to inventory turnover, but typically over shorter time frames. Better sell through means better inventory turnover.
Inventory Turnover Ratio Is a Gift
Any company in the business of moving inventory from one point of the supply chain to another must be aware of their inventory turnover ratio.
Not only that, they must be aware of their historical and ideal inventory turnover ratios. By benchmarking your turnover and comparing recent numbers to it, you determine how good your business is at turning raw materials into finished goods. And how to get better at it.