What is Inventory Turnover Ratio?

What is Inventory Turnover Ratio?

Rhema Hans
Rhema Hans
Table of Contents
Table of Contents

The success of any business is marked by how efficiently and effectively the company resources are utilized. So, monitoring your company's revenue is not enough. What you must also do is evaluate how often the resources are replaced. Moreover, when you are wheeling and dealing with a myriad of resources, it is essential to keep an account of everything. Be it the manufacturing, selling, or restocking of goods.

The Inventory Turnover Ratio can help you track, optimize and manage resource consumption.

Inventory turnover ratio is one of the most important ratios in the list of financial ratios that help you examine your financial health efficiently. So, let’s learn more about Inventory Turnover Ratio and its benefits. But before we move on, let’s understand what we mean by inventory.

What is Inventory?

Inventory is the accounting of raw materials or components an organization uses to further produce goods or sell the raw materials. It refers to the available stock of resources required in various stages of production. But this is just the tip of the iceberg. As we begin to learn about the Inventory Turnover Ratio, you will explore in detail what it has in store for you, so stay alert!

You can find more about inventory management and inventory accounting.

Note: To find your inventory (classified as a current asset), all you need to check is your company’s Balance Sheet.

What is Inventory Turnover Ratio?

In a business, failing to keep up with the customer's demand is the biggest nightmare. One of the common reasons for that to occur would be a shortage of inventories. And especially if you are a small business, beware, a shortage of goods is not something you even want in your records.

But let’s think about it this way. What if you knew exactly when you needed to restock without having the fear to overstock? This is where the Inventory Turnover Ratio makes a debut.

The Inventory Turnover Ratio is the number of times a company sells or replaces the inventory during a given period. This calculation of inventory turnover is a gateway to many possible company benefits. Mentioned below are a few benefits you might want to know before we learn how to calculate Inventory Turnover Ratio.

7 Reasons Why Inventory Turnover Ratio is Important

Inventory turnover is significant to a company in many ways:

  • Organizations often have a lot of cash tied up in their inventory. On an off chance, if the items in stock do not get sold, the organization will barely have any cash available to pay its- employees, banks, bills, suppliers, lenders, and so on. Therefore, with the help of the Inventory Turnover Ratio, you can exactly estimate the amount of inventory to replace instead of blindly stocking up.

  • Additionally, if your inventories turn out to be less in demand eventually, or even become outdated, maybe even disintegrate. It will directly translate to a loss of a portion of the company's capital. Therefore, monitoring the inventory turnover ratio is a must as it helps you keep track of movement in the goods over time.

  • Another reason why the Inventory Turnover Ratio is a go-to for a successful operation of any business is- When you have inventories in large quantities and less demand, it will take up a lot of valuable space in the warehouse.

  • Since the Inventory Turnover Ratio indicates high or low demand of goods, it prepares you for restocking and prevents you from overstocking. Here is an example: in case of high inventory turnover, a company must constantly purchase goods. If you fail to monitor your inventory turnover, it risks losing customers due to a lack of goods available.

  • Inventory Turnover Ratio also illustrates poor inventory planning and the need for new techniques to improve stocks and your business in general.

  • It helps you analyze how fast your organization is selling its stocks and comparing its efficiency in selling the goods against the industry standards.

  • Inventory Turnover Ratio can also help you measure the liquidity of your organization. For example, If your organization has a high inventory turnover ratio, it means higher liquidity- because it indicates that you as a company has sold inventories in large amount and received money from customers more often.

7 reasons why inventory turnover ratio is important for any business

Now that you know why Inventory Turnover Ratio is so crucial to your business. Look at how to calculate it with a simple formula.

How to Calculate Inventory Turnover Ratio?

Formula to calculate Inventory Turnover Ratio:

Inventory Turnover Ratio= Cost of Goods Sold / Average Inventory

Here is how to calculate cost of goods sold (cogs).

Once you have your ratio ready, how do you know if your business is on the more strong side of things or weak?

Inventory Ratio between 4 to 6 is generally a good ratio! It indicates that both restock rate and sales are balanced.

Low Inventory Turnover Ratio

A low Inventory Turnover Ratio indicates that there are slow-moving sales. Also, business deals that perhaps did not turn out in the best interest of the company. It can also possibly imply overstocking.

High Inventory Turnover

A high Inventory Turnover Ratio indicates that the item sells above average or your company has had profitable deals.

What is the Ideal Inventory Turnover Ratio?

Supply, demand, profit, or loss, along with the internal functioning of your organization, are all interrelated factors indicating the future of your company. Most importantly, the Inventory Turnover Ratio determining the financial health of your business. Whether a company big or small, you need to have a good Inventory Turnover Ratio for a brighter tomorrow.

As we mentioned above, Inventory Turnover Ratio between 4 to 6 is generally a good ratio!

Higher Inventory Turnover Ratio is a good sign:

Higher Inventory Turnover Ratio reflects the quick sale of goods and higher demand of goods. However, a high inventory ratio may also indicate lost sells, because a company failed in keeping up with high demands.

Low Inventory Turnover Ratio is a bad sign:

It indicates weaker sales and decreasing demand for the products.

However, every company is different in terms of its goals, objectives, and numbers. So, your ideal Inventory Turnover Ratio depends on the following factors:

  • Size of your Organization
  • Cashflow
  • How quickly you can liquidate your assets
  • Products you sell

Inventory Turnover by Industry is another parameter that will help you set an ideal Inventory Turnover Ratio.

Inventory Turnover by Industry

You first recognize the nature of your company and make developments keeping the market trends in mind. It will not only help you find your ideal Inventory Turnover Ratio but also boost it.

Following are the types of industries with specific requirements your Inventory Turnover Ratio needs to meet. And we also tell you what can you can do to achieve your goal.

Low-margin Industries

Grocery stores, dairy shops, stationery stores, and so on belong to low-margin industries. The companies with a low margin are to maintain a high inventory turnover rate to remain in profit. The best option to stay afloat in this market is to practice a quick movement of inventories.

High-Holding Cost Industries

Automobiles, electronics, textiles companies are a part of this fast-paced growing industry. New developments are taking place frequently today. While it is crucial to keep up with the trends, remember to maintain your Inventory Turnover Ratio, too. An easy way to go about it is by initiating a quick movement of your stocks.

Luxury Industries

Luxury industries have a niche market which results in low Inventory Turnover Ratios. However, the high-profit margin is a constant in this industry.  

That said, the Inventory Turnover Ratio may vary with time. The trend in the market is ever so rapid that it directly impacts your Inventory Turnover Ratio too. Most crucially, how well planned your inventory movement is.

The Bottom Line

The Inventory Turnover Ratio is the key to foreseeing the future of your business and making decisions at the right time.

If you also want to understand the whereabouts of your inventory turnover but have no go-to to calculate the Inventory Turnover Ratio, get started with Deskera today.

Deskera comes with complete inventory management tools and reports to help you manage your inventory better. You can start a free trial and see how it helps you.

We hope that the article helped you understand the nitty-gritty of the Inventory Turnover Ratio. Most importantly, its benefits, how to calculate it, and how Deskera will help you do it efficiently.  

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