Tracking your inventory is the first step to understanding your business trends.
You can’t get a complete pulse on your inventory, though, without knowing the rate at which your products are sold during any given month, quarter or year. This is your inventory turnover. By knowing this metric, you can better determine when it’s time to order new items and develop a stronger picture of the way items move through your business.
What does your inventory turnover mean?
Turnover is the rate at which you need to replace your inventory. Return on assets (ROA) is the money you receive in exchange for the items you sell. Your inventory ratio can help you figure out your ROA and give you an idea of the profitability.
Simply sell your inventory at a good rate, make a profit and then see a good return.
When you have items on hand for a lower number of days, it’s usually an indication that you have strong sales, or that you’ve priced items with a huge discount to sell them quickly.
When your inventory turnover is low, it usually means weak sales. If you can pinpoint the reason your sales are weak and your turnover is low, it can help you make adjustments. Maybe a product is out-of-date, flawed or not in trend. Take steps to liquidate the asset so you can replace it with something else.
How to determine inventory turnover
There are two main methods used to figure out the inventory turnover ratio. Both approaches can provide you with insight, though they have different purposes.
How to calculate:
Sales ➗ your average inventory.
Cost of goods sold ➗ your average inventory.
To calculate the average inventory, combine your beginning and ending inventory amounts for a given time period. Then divide that figure by two.
Applying the formulas
Let’s say you are a company with $2 million in sales for the year, and your cost of goods sold is $700,000. You have an average inventory of $50,000. Using this information, you can use both inventory turnover formulas to get an idea of where you stand.
$2,000,000 ➗ $50,000 = 40
This means your inventory turnover is about 40 times per year. If you want to break it down to see how many days you have the inventory on hand, divide that by 365. You’ll come up with a little more than nine days—meaning products sit on the shelf for about nine days before they are purchased.
- Easy to calculate.
- Gives an overall picture of the inventory and turnover.
- Includes your sales, which means the markup is counted into the calculation.
- Doesn’t account for seasonal cycles.
$700,000 ➗ $50,000 = 14
This means you’ll see an inventory turnover 14 times a year. If you want to determine what that means in days, divide by 365. You’ll discover you have inventory on hand for about 26 days.
- More accurate.
- Better accounts for seasonality.
- Does not include markup.
- Requires more details to calculate.
What does this mean?
If you have items on hand for a long period of time, it might be an indication that you need to change your approach. On the other hand, if you have a high turnover, that is often an indication that your products are in demand. If your turnover seems unusually high, this could be a clue that you are pricing your products too low and need to adjust the price so that you can increase your profit margins.
As you pay attention to your turnover, you will eventually get a feel for what the numbers tell you and be able to adjust your business accordingly.