Efficient inventory management is a key to business success. The faster inventory is sold out, the better. Non-selling inventory is a stressor, fast-selling inventory is a relief, which frees cash and allows business to grow.
Retailers’ ability to convert inventory into cash is called inventory ratio. Put simply, this is the rate at which goods are sold and the number of times a retailer replenishes its stock over a limited timeframe. The inventory turnover is also known as the stock turnover ratio.
Inventory turnover is a strategically important measure, which compares inventory level with sales and points out soft spots of a retailer that can be related to inaccurate stock planning or poor sales.
LOW RATE OF INVENTORY TURNOVER VS HIGH RATE OF INVENTORY TURNOVER
A low rate of inventory turnover means that a retailer has invested too much into inventory, either due to a flawed stock planning system, or errors in predicted sales. The risks of inventory being spoiled, going out of trend, or reaching its expiration date are high. In any case, excess inventory means tied up operating capital.
To sum up, a low inventory turnover ratio can indicate that a retailer has held its goods in the warehouse for too long, has purchased too many goods, or marketing efforts should be ramped up.
On the other hand, a high inventory turnover indicates high business performance and synchronization of stock planning processes and sales. A high inventory turnover ratio shows that a retailer is selling its goods fast, not wasting too much money on excess inventory and storage, and effectively managing its stock.
An extremely high inventory turnover may also mean that a retailer is in debt, not buying adequately, or does not have the funds to replenish its stock. All this inevitably leads to low inventory levels and losses in sales.
How to calculate the inventory turnover ratio?
Three simple steps to follow:
1) Calculate the total cost of goods (or “COGs”) sold within a period.
This can be taken from the annual income statement, for example.
FYI: COGs calculates the total amount of goods (plus logistical costs) received from a supplier to a warehouse within a time period.
2) Determine average inventory cost.
This can be done by adding the ending inventory balance and the beginning inventory balance and dividing by two. We do not recommend using the ending inventory balance because during the year some fluctuations may happen that should be taken into account.
FYI: Average inventory is the average cost of goods during two or more periods. It is calculated using the beginning inventory and ending inventory at the beginning and end of a fiscal year, respectively.
3) Divide the cost of goods solved by average inventory cost.
Inventory Turnover Ratio = COGS/Average Inventory
This year, a retailer, company X, sold its goods worth 5 million USD. The beginning inventory cost was 600,000 USD, ending at 400,000 USD. So, the average inventory cost equals 500,000 USD, and inventory turnover is rated 10 times a year.
The inventory turnover ratio usually differs from one industry to another. It depends greatly on the product types and size of the business. For example, retail, mass-market fashion and supermarkets have a higher inventory turnover rate, because they hold large volumes of inventory at low margins. The inventory ratio of a supermarket is 18-20. It needs a high sales rate to balance low profit per item.
What is Days Inventory or DSI?
DSI, or Days Sales of Inventory, is a measure that shows how many days are needed to convert inventory into sales. It’s easy to calculate and important to measure. Just divide 365 days a year by your turnover ratio.
DSI = 365/Inventory Turnover Ratio
This measure is very important, as it shows the real-time needed to turn inventory into cash. And, of course, low DSI is good – fewer days to sell, more cash received. However, the DSI rate differs depending on the industry. Supermarkets and groceries enjoy lower DSI because of the nature of their business compared to, for example, luxury car dealers. So, for healthy and efficient benchmarking, one should compare companies of the same industry and size.
How to make the inventory turnover rate favorable?
So, the inventory turnover ratio and DSI are very important measures for retail companies, as they show the effectiveness of inventory management and overall company performance. Usually, a higher inventory turnover ratio is preferable.
To increase the inventory turnover ratio, you must use a trusted and reputable inventory management system that tracks demand and makes a real-time analysis of stock, preventing you from overstock and backorder situations. Secondly, you must use efficient inventory management techniques, which are automatically implemented in modern inventory management software. These intelligent systems keep track and predict demand, make forecasts, do the accounting and marketing work, and, as a result, automatically replenish your stock at the right time in the right amount. And, of course, a strong sales strategy and smart marketing techniques always go hand in hand with inventory management.