What is a Good Inventory Turnover Ratio?

How efficiently are you managing your inventory levels? Every item in your warehouse represents a finite amount of money that’s just sitting on the shelf, tying up funds that might be better invested elsewhere. If your objective is to maximize return on capital, then too much inventory translates to lackluster results.

Excess goods consume valuable space. That costs money. High inventory levels also mean higher insurance premiums, increased taxes, and other carrying costs. Stagnant product can lose its value through obsolescence, theft, expiration, or breakage. That eventually results in write-offs that further erode profitability.

On the other hand, you don’t want to run out of stock on popular items. Customers may turn to your competition to fill immediate needs, leading to lost sales and potentially lost customers.

By maintaining an ideal inventory turnover ratio, businesses can track and improve the efficiency with which they are managing one of their most critical assets. But what constitutes a good inventory turnover rate? Will discuss that, and a lot more, in this article.

Understanding Inventory Turnover Ratios

First, let’s define what we mean by inventory turnover. You may hear a variety of different terms to describe this metric, including “stock turnover ratio,” “inventory turns,” or simply “turnover.”

Average inventory turnover ratio is a financial metric that indicates how many times a company's inventory is sold and replaced over a specific period, typically a year. It provides insights into the efficiency of inventory management and the effectiveness of sales strategies.

The inventory turnover formula is simple. Start with the Cost of Goods Sold (COGS), which is the total cost incurred to produce the goods that your company sold during a specific period. Divide that by the average inventory level for the same period. To determine average inventory, most companies simply take the average of the starting and ending inventory numbers.

The Importance of Your Inventory Turnover Ratio

Average inventory turnover is a valuable indicator of the efficiency with which an organization uses its working capital.

A high inventory turnover ratio generally indicates that a company is managing its inventory efficiently and effectively. It often reflects strong sales, where products are being sold and replaced frequently. It can also mean a higher risk of stock-outs, though, or an over-dependency on just-in-time (JIT) inventory. If customers are placing orders and you don’t have the goods to fulfill them, that will cut into your sales revenue.

A low inventory turnover ratio usually indicates that an organization is not managing its assets efficiently. It may be a sign of lagging sales. It generally means higher carrying costs and an increased risk of having obsolete inventory that loses more and more value with the passage of time.

Inventory Turnover Calculation: An Example

Let’s look at an example that demonstrates how the inventory turnover ratio formula works:

Last year, Acme Supply, Inc. started with inventory valued at $1.2 million, and ended the year with $1.6 million in inventory. Through the course of the entire year, their Cost of Goods Sold was $9.8 million.

Acme’s average inventory was $1.4 million (that is, the average of $1.6 million and $1.2 million.)  Divide the COGS of $9.8 million by the average inventory of $1.4 million, and we get an average inventory turnover ratio of 7.

Performing an inventory turnover calculation is generally quite simple because a company’s financial statements typically include both the cost of goods sold and an ending inventory value. Using information from the current income statement and balance sheet, and from the prior year’s balance sheet, you can calculate stock turnover quickly and easily by applying this inventory turnover ratio formula.

Potential Pitfalls in Inventory Turnover Calculation

Here are some of common mistakes that we see when calculating inventory turnover:

·       Using total sales instead of COGS: If you mistakenly use total sales as the numerator in your inventory turns formula, you’ll end up with an artificially high turnover ratio. The calculation should be based on the cost-basis of the inventory, not its sale price.

·       Not using average inventory: Using the ending inventory instead of the average inventory can lead to inaccurate turnover rates, especially if you’re beginning and ending inventory numbers are very different. Average inventory is calculated by adding the beginning inventory to the ending inventory and dividing the result by two.

·       Ignoring seasonal variations: If you are calculating inventory turns based on an entire year, chances are that seasonal variations will not come into play. If you’re starting and ending dates fall in different seasons, though, that can distort your results.

·       ignoring different inventory types: Different types of inventory, such as raw materials, work-in-progress, or finished goods, can have widely different turnover rates. In order to avoid a skewed turnover ratio, consider treating these as separate categories of inventory.

Note that different inventory valuation methods (FIFO, LIFO, Weighted Average) can affect both the COGS and inventory values, thereby impacting the turnover ratio. If your organization has changed its valuation method during the period that you are analyzing, it’s critically important that you adjust your numbers to account for that. Consistency in the valuation method used is essential for accurate comparisons.

Why Inventory Turnover Ratios Matter

Why is your inventory turnover ratio important? It can say a lot about the overall health of your company, including sales, cash flow of, and the overall efficiency and effectiveness of management:

Cash flow: Efficient inventory turnover helps companies maintain a healthy cash flow, because less money is tied up in unsold stock. A higher inventory turnover ratio indicates that relatively little cash is sitting on the shelf in your warehouse, which is a good thing, of course. It means you’re using your working capital efficiently.

Sales: While a low inventory turnover isn’t always an indicator of low sales, it does suggest that your product might not be moving off the shelves as fast as it should be. That might be true across the board, or it might be an indication that some of your products or slow movers. If your turnover ratio is lower than you expected, you might want to dig deeper. Are you stocking items that simply aren’t in high demand? Does it make good business sense to discontinue some of them, or do they contribute value in some way?

Dead stock: If some portion of your inventory isn’t moving at all, that will negatively impact your inventory turnover ratio. Not only does that amount to money sitting on the shelf, – you’re also incurring storage costs that undermine your profitability. Many business owners will prefer to liquidate obsolete goods and bring in new products that appeal to today’s buyers.

What’s a Good Inventory Turnover Ratio?

That brings us to a very common question: What is a good inventory turnover ratio? In other words, how can you tell if you are managing your inventory efficiently?

Unfortunately, there is no one-size-fits-all answer to that question. The so-called “normal” inventory turnover ratio can vary significantly depending on your industry and the type of products you sell.

Clothing retailers, for example, typically fall between four and six turns per year. General merchandise wholesalers might be a bit more efficient, at six to eight inventory turns per year.

Industries that sell perishable goods, on the other hand, typically have much higher inventory turnover ratios. Grocery stores typically turn over their inventory at a rate of 10 to 20 times per year, with many products moving off the shelves within days, and some non-perishables taking longer to sell. Food and beverage manufacturers, likewise, have a higher average turnover ratio than manufacturers of durable goods such as cars and trucks, appliances, or furniture.

Industries with particularly high margins may be less likely to concern themselves with high turnover. Pharmaceuticals, for example, generally have a reasonably long shelf life and high profit margins, with average turnover falling between 2 and 3. High-end luxury goods, likewise, carry a hefty margin that makes carrying costs look tiny in comparison. The parent company that owns the Louis Vuitton brand, for example, reported an inventory turnover ratio of just 0.61 for 2023. [SOURCE]

As a general rule of thumb, though, a reasonable inventory turnover ratio is between 5 and 10 for most industries, which indicates that you sell and restock your inventory every 1-2 months.

Factors That Affect Your Inventory Turnover Ratio

There are a number of factors that can lead to higher or lower inventory turnover ratios. Here are some of the more significant ones:

Seasonality: Products like holiday decorations, winter clothing, or summer sports equipment are subject to strong seasonal demand. Their turnover ratios can be extremely high during peak seasons, with very low turnover during other times of the year when demand is virtually non-existent.

Perishable vs. non-perishable: Items like fresh produce, dairy, and meats have short shelf lives and require rapid turnover to avoid spoilage. Items with longer shelf lives, such as canned goods, household items, and motor vehicles, tend to have lower turnover ratios because they don’t need to be sold as quickly. Unsold inventory quickly becomes worthless.

Rapid obsolescence: Just as perishable goods lose value quickly, today’s technology products decline in value rapidly as newer, more innovative products come to market. Items like smartphones, laptops, and other electronics may have higher turnover ratios due to rapid technological advancements and short product life cycles.

Supply chain volatility: In recent years, global events have led to supply chain disruptions and uncertainty about the availability of both finished goods and raw materials. In order to ensure that they can continue to meet customer demand, many companies have shifted toward having higher levels of safety stock. In other words, they have dialed back their emphasis on efficiency in order to maintain sales and customer satisfaction.

Improving Your Inventory Turnover Ratio

Improving the inventory turnover ratio involves strategies that can help increase sales, reduce excess inventory, and optimize inventory management. Here are several methods to achieve a better inventory turnover ratio:

Sales and marketing strategies: Companies can dramatically impact the velocity of their inventory by offering special promotions, discounts, and bundles. When buyers respond to limited-time offers, that can lead to very rapid turnover over a short period of time.

Just-In-Time (JIT) inventory: This method helps companies reduce inventory levels by limiting the flow of incoming goods to only what is needed for current production or sales.

ABC analysis: This involves dividing your list of inventory items into three categories (A, B, and C) based on importance and turnover rate. By focusing on “Category A” items (high-value, high-turnover), companies can have a stronger impact on their overall stock turnover.

Demand forecasting and planning: Using advanced analytics and powerful software, companies are able to more accurately forecast demand, adjusting inventory levels accordingly.

Tools for Improving Your Inventory Turnover Ratio

Running a profitable business is all about the numbers. That’s especially true for businesses that must manage inventory and a supply chain. Today’s technology offers a faster, easier path to understanding the metrics that matter, and for taking action that improves your bottom line.

By bringing cutting-edge AI tools to your detailed transactional data, you can quickly gain a clear picture of what will move the needle for your enterprise. By better understanding the unit economics of your business, you can know which levers will most profoundly impact your profitability for the better. Want to increase your margins? Armed with detailed, accurate information about your unit economics, you can choose the best-fit strategies for increasing profitability in your organization.

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