Businesses that don’t understand accounting are destined to fail. That’s especially true for those who carry an inventory. Mismanaging inventory and cash flow are two sides of the same coin. Keeping a poor inventory could lead to issues with your business liquidity, like tying up excess capital to inventory or missing out on sales opportunities due to stockouts.
Fortunately, there are a few easy-to-track metrics, like the Inventory Turnover Ratio, that your business can monitor to leverage its inventory to thrive.
What’s Inventory Turnover?
Put simply, inventory turnover is the measure of how many times a business sells its entire inventory. It’s a key metric for companies that sell any products which helps them have a better understanding of how efficiently their inventory is being managed.
Typically, the inventory turnover is measured over 12 months, but businesses might also opt to track the turnover quarterly or even monthly.
Why Does Inventory Turnover Matter?
It might appear insignificant at first glance. But, knowing your inventory turnover can help you and your business make critical spending decisions and mark the difference between a business that dies and one that thrives.
Inventory turnover is a key component of maintaining healthy cash flow and a valuable tool to identify and solve supply chain challenges.
For example, not turning over your inventory as often as you should could be indicative of needing to invest more in marketing or needing to revamp your sales team. It can also give you an idea of when it’s a good time to raise your product prices or introduce discounted offers.
What’s the Inventory Turnover Ratio
The Inventory Turnover Ratio is a formula that calculates the number of times a company sells and replenishes its inventory. It also calculates the number of days it typically takes to do it.
For example, let’s assume you’re the owner of a brick-and-mortar clothing store, and your most popular T-shirt design is delivered from the manufacturer in pallets of 1000 units. Once your store sells 1000 T-shirts, you will turn your inventory over once.
Now, let’s assume this happens exactly once per month. In that case, your Inventory Turnover Ratio in a year would be 12 because you’re buying and selling your inventory 12 times in a year.
What Is The Formula For Inventory Turnover Ratio?
There are various ways to calculate the inventory turnover ratio. However, the most common method consists of dividing the costs of goods sold by the average inventory for the year.
Inventory turnover = Cost of goods sold / Average inventory
But to calculate inventory turnover using this method, you’ll first need to solve for the cost of goods sold and the average inventory.
Finding The Cost of Goods Sold (COGS)
To find the total cost of goods sold, you’ll need to know the inventory count at the beginning and end of your tracking period.
To solve for COGS, you need to take your initial inventory count, add any inventory purchases you’ve made over the period you’re tracking (E.g., One year), and subtract the inventory you have left at the end of the period.
Cost of Goods Sold (COGS) = Beginning inventory cost + Purchases – Ending inventory
Going back to the previous clothing store example, let’s illustrate how to calculate COGS for your brick-and-mortar clothing store.
To solve for the beginning inventory we first need to know what each T-shirt sells for. In this case, let’s say they cost $49. If we assume your business had 300 T-shirts in inventory at the start of the year. If so, the value of your beginning inventory would be $14,700 ($49 x 300 T-shirts).
Now, let’s assume you purchased another pallet through the year ($49 x 1000 T-shirts) and ended up with 500 T-shirts ($49 x 500 T-shirts) in your inventory by New Year.
If so, your COGS would be calculated as follows:
COGS
$14,700 + $49,000 – $24,500
Your COGS for the year would be $39,200.
Finding The Average Inventory
The average inventory is the second part of the inventory turnover formula we need to solve. To calculate the average inventory for the year, all you need to do is add the cost of the initial inventory to the ending inventory at the end of the year and divide that by two.
Average Inventory Formula =
Beginning inventory cost + Ending inventory
For example, let’s say your store ended the year with 500 T-shirts and your initial order was 1000 T-shirts. In that case, your average inventory would be 750 because:
Average Inventory
1000 + 500
Alternatively, you can find your beginning and ending inventory by using an ERP system like XLedger.
XLedger is an inventory management and accounting system that can help you manage your inventory, reduce errors, and forecast efficiently without the need to use spreadsheets or calculate manually.
Streamline your inventory and accounting by using online ERP software here.
What is a Good Inventory Turnover Ratio?
Typically, you’ll want your inventory to turn over as quickly as possible. Each time your inventory turns around, you’ll be able to reinvest your initial capital to replenish your inventory and make more profits.
A high inventory turnover generally indicates efficient inventory management. However, a fast turnover ratio is not always a positive omen. Selling your inventory too fast could also indicate you’re underpricing your products.
On the other hand, turning over your inventory too slowly could be a sign of needing to invest more in marketing, upgrade your sales team, or of wider market problems.
So, what’s the best way to find the right inventory turnover ratio?
One of the most efficient strategies to determine whether your business is turning around inventory at a healthy pace is by comparing your ratio with those in your industry or the industry as a whole.
Not all industries are created equal. High-ticket or luxury products tend to have much lower turnover ratios than, for instance, everyday staples. That’s why weighing your results against the wider industry or similar businesses can help you find a fair approximation.
You can find them by checking earnings data from public companies in your industry on sites like Morningstar.
For example, you can navigate to Morningstar by clicking here and see that Macy’s turnover ratio last year was 3.67.
Alternatively, you can explore sites that provide industry estimates like this one.
How to Boost Inventory Turnover Ratio With Software
Keeping track of inventory with spreadsheets and manual work can consume many resources from your finance and accounting team. That’s why modern accounting teams are adopting online ERP software that can automate accounting processes and gather inventory data in real time.
At Xledger we provide a fully integrated inventory and stock accounting system for medium and large businesses that offers multiple stock valuation methods like FIFO and Average/Fixed Value.
Our Cloud-Based Inventory Management system also offers multiple stock valuation methods, stocktaking, adjustments, transfers, write-offs, and automatic replenishment orders.
It starts by booking a free one-on-one demo with our team of experts. From there, our team will guide you every step of the way.
Free your finance team from tedious and repetitive inventory management tasks and get in touch today.