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Calculating Your Inventory Turnover Ratio
As an accounting professional, understanding a business’s inventory numbers is essential to providing valuable advice. It may matter more for large retailers dealing with thousands of SKUs, but it still matters even if a company is manufacturing a single product and shipping it off to a sole distributor. Accurate inventory data is essential for operational workflow and customer satisfaction–if somebody tells a customer they have an item and don’t, the customer going to be angry. When you have accurate inventory records, you can use them to create insightful figures easily understood by business owners. One piece of data you should know related to inventory is called the inventory turnover ratio.
An inventory turnover ratio lets you know how many times a business turns over inventory in a given year. It is not calculated on an item-by-item basis, but instead gives you a sense of how often a business are selling and replacing the dollar value of your inventory. If your inventory turnover ratio is too low, you’re holding onto products too long and tying up resources in stock that doesn’t sell. As businesses grow larger, they’re inventory turnover ratio tends to shrink. The range that comprises healthy numbers for a company will depend on its industry and size.
Calculating Inventory Turnover Ratio
The basic formula goes as follows:
Cost of Goods Sold (COGS) / Average Inventory = Inventory Turnover
You should already know your CGS, but average inventory is a less commonly calculated metric. The reason it’s important to use an average is because many product-heavy businesses are busier at certain times of the year. A retailer’s inventory on January 1 is probably a lot lower than it is in the lead up to Black Friday. You could take two inventory numbers, add them together, and divide by two to get an average inventory. If you have the data, you could also take inventory figures for each month, add them up, and divide by twelve.
Once you have an average inventory and divide it by the CGS, you have the inventory ratio. This number represents the number of times you turn over the average value of inventory in a given year. If you want to convert that number into the average number of days it takes to sell through the value of inventory, called the days sales of inventory (DSI), you can do so with the following formulas:
(all formulas taken from Investopedia)
The Importance of Inventory Turnover
Inventory turnover is a crucial data point for a number of reasons, but the most important is that is assesses important aspects of overall business health. If a company is running a low turnover ratio, they likely have either too much stock or too many items customers don’t want. On the other hand, a sky-high ratio could mean a company struggles to meet demand and keep products in stock. As with any piece of data, inventory turnover ratio should be used in context with other information about the business.
You can also run experiments to make the numbers even more interesting. What happens to the ratio if you remove a client’s best-selling product? What happens if you remove the 50 least popular SKUs? Information like this allows you to become a trusted advisor to your clients. When you have figures like inventory turnover ratio, you’re not just amassing data; you’re using it to help a business operate better going forward.
How AccountingSuite Can Help
AccountingSuite has best-in-class inventory management features that give you access to all the facts and figures necessary to generate actionable reports for your clients. In many industries, inventory data is a strong indicator for the overall health of a business. Don’t let your clients remain in the dark when it comes to insights that make them more efficient and make you more valuable. Give AccountingSuite a shot today.
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