If your small business has inventory, knowing how fast it is selling will help you better understand the financial health of your business. Here’s why inventory turnover ratio is important and how to calculate it.
What Is The Inventory Turnover Ratio?
The Inventory Turnover Ratio, or ITR (a.k.a. stock turnover ratio) measures the number of times a business sells and replaces its inventory over a certain period.
A higher turnover ratio means that a company is selling more and replacing its inventory faster. The calculation of inventory turnover ratio is essential for a business to track its performance and can help identify areas for improvement.
Why Do You Need It?
The inventory turnover ratio is a valuable metric for businesses. It should be part of your overall effort to track performance and identify areas for improvement.
Inventory management helps businesses make informed decisions about how much inventory they need to keep on hand and how quickly they should replace it. Additionally, it helps businesses to identify problems such as stockouts, excess inventory or slow-moving products.
You want to be able to answer questions like:
- What’s selling quickly?
- What is not?
- Am I paying for storage for too long?
- Do I have enough inventory to meet expected demand?
- When am I likely to run out of inventory?
- When is the optimal time to restock inventory?
And perhaps most importantly, inventory turnover affects cash flow. Inventory purchases cost money, and if you sell items too slowly, you aren’t turning that inventory into revenue any time soon. Storage costs on unsold inventory add up, and will reduce your profit margin. Understanding what’s not selling can help you understand whether you need to adjust pricing by offering discounts or even dispose of dead stock.
How To Calculate Inventory Turnover Ratio (ITR)?
The basic inventory turnover ratio formula is:
ITR = cost of goods sold divided by average inventory cost
You will need to choose a time frame to measure the ITR, such as a month, quarter, or year since you’ll use the inventory turnover formula to calculate your ITR over a specific period of time.
Then you’ll calculate the ITR by dividing the cost of goods sold by the average inventory value.
Your cost of goods sold (COGS) over that time period can be found on your financial statements, specifically the income statement, which should be available from your business bookkeeping software, or your accounting staff or professional.
The average inventory value is calculated by taking the average of the beginning and ending inventory. (For example, if you are calculating ITR for a quarter you can average 3 months of inventory ending value and divide by three.)
Once these figures have been determined, the inventory turnover ratio can be calculated by dividing the cost of goods sold by the average inventory value.
In general, a higher ITR means the business is turning over inventory more quickly (and likely paying less to store inventory as well).
Find Out Your Industry Average Inventory Turnover Ratio
Understanding how your business stacks up against others in your industry may be helpful to understand your business performance. What is a good inventory turnover ratio for your business and industry may be completely different from that of another.
A grocery store will have a higher inventory turnover rate than a business selling specialty packaged (non-perishable) gourmet foods, for example.
If you’re looking for free resources, you may want to check with your local library or Small Business Development Center to learn about market data that may be available for free or low cost.
Points To Consider When Looking At Your Business’ Inventory Ratio
There may be a number of factors that can affect the ITR at any given point in time so you’ll want to take these into account:
- Marketing campaigns
- Ordering problems
- Supply chain issues
Inventory management software, or enterprise resource planning (ERP) software, can often be helpful in tracking inventory at a very detailed level.
Inventory Turnover Optimization Techniques
There are a number of ways you can approach improving inventory turnover, and what will work for your business depends on lots of different factors. But here are some to keep in mind:
1. Analyze Inventory Levels: Analyzing inventory levels is the first step in optimizing inventory turnover. That’s why you’re calculating the ITR in the first place! This can be done by looking at the current inventory levels compared to the average inventory levels for the same period in previous years.
2. Implement Just-in-Time Inventory Management: Just-in-time inventory management is a system that allows businesses to order and receive inventory only when it is needed. This helps to reduce the amount of inventory that is held in stock, which can help to reduce inventory costs, storage costs and improve turnover.
3. Utilize Inventory Management Software: Automated systems can be used to track inventory levels, order new inventory, and even generate reports. Inventory management software can provide valuable insights while reducing the amount of time and effort required to manage inventory. Automate these tasks so you can focus on getting product out the door.
4. Utilize Cross-Docking: Cross-docking is a system where inventory is received from a supplier and then immediately shipped out to customers. This helps to reduce the amount of time and effort required to manage inventory, with little or no storage.
5. Utilize Barcoding: If your business is not already using barcodes, it should be one of the first things you investigate to improve your inventory management. Barcoding is a system where each item is assigned a unique barcode. It can save time and money, and can make it easy to use inventory management software.
6. Utilize Vendor Managed Inventory: Here you don’t manage your inventory levels— your vendors do. This can help to reduce the amount of time and effort your business must spend to manage inventory, since the vendor is responsible for ordering and delivering the inventory when it is needed. It is not available for all industries or products, but it can be worth checking out.
7. Increase Demand. Whether it’s running sales, bundling products, or investing in digital marketing campaigns, selling more inventory more quickly can help you improve your inventory turns.
Why Calculating Inventory Turnover Ratio Helps With Business Financing
Calculating inventory turnover ratio helps with business financing in a couple of ways. Borrowers can use this information to help determine how much inventory financing they need, and for how long.
For small business lenders it can help them understand how efficiently a business is managing its inventory. A high inventory turnover ratio indicates that the business is selling its inventory quickly and efficiently, and strong sales are a positive sign for lenders.
A low inventory turnover ratio, on the other hand, indicates that the business is not selling its inventory quickly enough, and weak sales could be a sign of financial trouble.
Not all lenders will review a businesses; inventory turnover rate, but for those that do, it can help them make more informed decisions about whether or not to provide financing, or whether to require collateral for inventory financing.
Line of Credit
A line of credit allows a small business to borrow as much as it needs, up to the limit, when needed. Once you pay it back, you can borrow again.
Cash Flow Loans
You may be able to secure financing based on your business revenues. This short-term financing can be easier to qualify for but some options may carry higher costs so choose wisely.
Business Credit Cards
By timing your purchase right, you may be able to get up to two billing cycles of float on your business credit cards without paying interest. In addition, some business credit cards offer intro 0% APR financing for a limited period of time. (And business credit cards can often help you establish business credit.)
This article was originally written on February 3, 2023.