This article is a guest post, written by Unleashed Software. Unleashed’s online inventory software helps businesses better manage their inventory.
Effective and efficient inventory management is crucial to the profitable running of any inventory-based business, which is why you should know your company’s inventory turnover ratio. With this in mind, there is one simple accounting formula that inventory-based enterprises use to calculate just how well they are controlling the flow of inventory through their supply chain.
In short, the inventory turnover ratio allows a business to calculate the rate at which it acquires and resells goods to its customers. This allows a business the ability to clearly assess how well it is performing and whether it needs to either buy in more inventory or cut back on purchasing.
Because the two extremes of poorly managed inventory – overstocking and stockouts – place considerable burden on the bottom line of a business, it is crucial that an in depth appreciation of the rate at which inventory is being turned over is gained.
Armed with this financial information, operations managers are much better able to address costly build ups of stagnant stock in storage as well as forecast and purchase in-demand stock to meet customer service targets.
How the Inventory Turnover Ratio is Calculated
The most basic formula for calculating your business’ turnover ratio (i.e., the of times inventory is turned over within a given period) is to divide net sales by inventory.
Turnover Ratio = (Net Sales) / (Inventory)
The net sales figure is taken directly from the Income Statement of the company and the inventory number from the Balance Sheet.
So, for example, if a business’ annual net sales as recorded on its Income Statement is $2,000,000 USD and its inventory as recorded on the Balance Sheet is $200,000 USD, the turnover ratio (the amount of times within a year that it purchases and sells off its inventory) will be $2,000,000/$200,000 = 10 times.
A High Rate of Inventory Turnover
A company’s performance is directly linked to how well it manages its inventory. Typically, a business that boasts a high rate of inventory turnover can rest assured that it is managing the flow of inventory through its business proactively and profitably.
Generally, less inventory on the shelves results in less risk as a result of damages and obsolescence, as well as greater protection against fluctuations in market prices. If a business is stuck holding on to a surplus of unnecessary inventory and the market suddenly dips along with the retail price of those goods, then significant losses can be sustained.
The one potential red flag raised by a notably high inventory turnover rate is the risk of running into a stock-out situation. This is where a business does not have enough stock on hand to meet sudden surges in demand. This then leads to loss as a result of missed sales, customer dissatisfaction and even lost customer allegiance.
A Low Rate of Inventory Turnover
If inventory is turning over at a sluggish pace, then a business is not maximizing its ROI (return on investment). Low turnover rates are symptomatic of a business that is overstocking inventory and therefore wastefully limiting its available cash flow.
Worse still, is that a business that is unable to move its inventory efficiently automatically puts itself at risk to sudden market changes which could adversely affect the retail price of the goods it holds.
This will leave little choice but to either sell off at cost or liquidate stock at a loss. Either way, a low inventory turnover means that inventory is being managed poorly or sales are low. Both scenarios are bad news for business.
Effective inventory management software will help a business gain a sound appreciation of its inventory turnover rate. This is the first step in being able to address the issues that arise from carrying either too much or too little inventory.
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