While inventory managers typically look at stock levels, turnover, and other warehouse data, calculating for inventory to sales ratio gives companies a view of current assets in relation to the sales they generate.
The inventory to sales ratio accounts for two of the most crucial numbers in a company’s financial health—the cost of its products, and the revenue that comes from selling those products.
The most profitable businesses can balance their capital investments with their projected sales. In this article, we explain how to calculate your inventory to sales ratio and why it’s so important in business.
What is inventory to sales ratio?
The inventory to sales ratio (also known as I/S ratio or stock to sales ratio) compares a company’s total value of inventory against its sales for a given time period.
A KPI used in inventory management, the I/S ratio calculates how quickly a company can liquidate its stock and, therefore, the ideal amount of inventory it should keep on hand.
Inventory to sales ratio vs inventory turnover ratio
The inventory to sales ratio is often compared to the inventory turnover ratio, another metric used to track the purchase and sales of inventory. However, while many of the factors in both ratios seem similar, they each have distinct purposes.
When monitoring the purchase and sale of inventory, the inventory to sales ratio looks at the value or monetary cost, while inventory turnover looks at the number of units.
The I/S ratio compares the inventory value against the sales price. Inventory turnover focuses instead on the units of product.
Ultimately, the purpose of measuring the inventory to sales ratio is to verify that capital is being efficiently allocated to inventory that is likely to generate the most profit.
On the other hand, inventory turnover calculates how many times a product sells out in a given period. It reveals how well a company can sell its goods, as well as the accuracy of a company’s sales projections.
Why is inventory to sales ratio important?
The inventory to sales ratio is important in understanding the role inventory plays in a company’s overall expenses and cash flow. Taking inventory at its monetary value forces companies to see the significant cost of holding large quantities of products.
Inventory is usually the biggest expense in a company’s financial statement and should be balanced by a healthy inventory to sales ratio. If not, a company can find itself left with large amounts of unsold inventory and decreasing profits.
How to calculate inventory to sales ratio
To calculate the inventory to sales ratio, you need to first determine the average inventory value and net sales earned for a given time period.
The average inventory value is found by adding the beginning inventory value and ending inventory value and then dividing the sum by two.
(Beginning inventory + Ending inventory) / 2 = Average stock value
Net sales are calculated by taking the gross sales for the period (before discounts and returns) and subtracting any returns.
Gross sales – Returned sales = Net sales
Once these two numbers have been calculated, the inventory to sales ratio can be applied using the following formula:
Average inventory value / Net sales = Inventory to sales ratio
For example, a ceiling fan manufacturer carries an average inventory of 1,000 units monthly. Each fan costs the manufacturer $75 to produce, which results in an average inventory value of $75,000. In the last month, the manufacturer generated net sales of $150,000 after accounting for returns.
Applying the formula to this example, the inventory to sales ratio is 0.5.
$75,000 / 150,000 = 0.5
In other words, for every dollar sold, the manufacturing company has half the amount, or $0.50, invested in inventory.
What is a good inventory to sales ratio?
While it’s easy to assume that the lower the inventory to sales ratio, the better for business, this may not always be the case. Decreasing the amount spent on inventory can leave a company with insufficient inventory and unable to meet customer demand. This is especially risky during peak seasons, in high-growth companies, or when faced with unreliable supply chains.
In contrast, a high I/S ratio indicates a company is holding excess inventory above what it can sell in the projected time. It also incurs higher holding costs and may even see fewer profits if the dead stock inventory can no longer be sold at the expected price.
Some recommend aiming for an I/S ratio between 0.167 and 0.25. However, as in most cases, it’s best to find the ideal number for your business. Over time, calculating the inventory to sales ratio on a periodic basis will offer more insight into your sales cycle and total business growth.
How QuickBooks can help improve your inventory to sales ratio
Improving the inventory to sales ratio is much easier when all relevant metrics are automatically collected for you. QuickBooks Enterprise facilitates the entire process by tracking every inventory cost and sales order on a single dashboard.
Customizable reports can also be created to access critical information in a few clicks, and offer instant visibility across overall operations.
The instant an order is shipped, inventories are also updated in real-time. Drawing from the number of sales and other data, QuickBooks automatically calculates inventory forecasts and generates purchase orders with one click.
Automated processes reduce error and increase efficiency, enabling a business to better determine its ideal inventory to sales ratio and work toward increasing its bottom line.
Final thoughts
When it comes to running a profitable business, it’s important to look at how the numbers work with one another. High amounts of inventory don’t necessarily equate to more total sales. Conversely, decreasing spending for low inventory can leave a business without anything to sell.
The inventory to sales ratio effectively determines optimal stock levels and aid in making smart purchase decisions. Using QuickBooks Enterprise makes it even easier to implement sales ratio measures and automate the best reorder points to fulfill customer demand.
