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, it is the rate at which goods are sold and used within a limited measurement time, a number of times retailer replenishes his stock of goods over a period. 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 sales prediction. In any case, the risks of inventory being spoiled, going out of trends, or reaching its expiration date are high. And in any case, excess inventory means tied up operating capital.
To sum up, a low inventory turnover ratio can indicate that a retailer holds his goods in the warehouse for too long, has purchased too many goods, or the efforts of marketers should be fuelled up.
On the contrary, 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, effectively managing its stock.
A note bringing one cloud to the happiness - an extremely high inventory turnover may also mean that buying is not effective, or a retailer does not have enough money to replenish his stocks, or he has a high level of debt - all this inevitably leads to low inventory levels and losses in sales.
How to calculate the inventory turnover ratio?
A very simple three 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 is an actual money pad for total amount of goods (plus logistics costs) received from a supplier to warehouse within a time period.
2) Determine average inventory cost.
This can be done by adding the ending inventory balance and the beginning inventory - and dividing by two. We do not recommend using the ending inventory balance because during the year some fluctuations happen, that should be taken into account.
FYI: Average inventory is an average cost of goods during two or more periods. It is calculated using the beginning inventory and ending inventory, in the beginning of a fiscal year and at the end 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. Beginning inventory cost was 600,000 USD, ending - 400,000 USD. So, the average inventory cost equals 500,000 USD, and inventory turnover is rated at 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 and low margins. An inventory ratio of a supermarket is 18-20. They need high sales speed to balance low profit per each item.
What is Days Inventory or DSI?
DSI or Days Sales of inventory is a measure, which shows how many days it is needed to convert inventory into sales. Easy to calculate and important to measure. Just divide 365 by your turnover ratio (because one year has 365 days).
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 than 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, inventory turnover ratio and DSI are very important measures for each retail company, as they show the effectiveness of inventory management and overall company performance. Usually, a higher inventory turnover ratio is preferred.
To increase the inventory turnover ratio, you must use a trusted and reputable inventory management system that tracks demand and make a real-time analysis of stock, preventing you from overstock, and backorder situations. The second point - 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 - in due time and due size. And surely, strong sales strategy and smart marketing shall always go hand in hand with inventory management.