What Is Inventory Turnover?

Keeping Track of Inventory

 

Managing a company’s inventory is a hard thing to do, but is made much easier these days by utilizing a robust inventory management system. By implementing a software system to manage inventory, your business can create efficiencies that can significantly ease current employee workload, and in effect causing them to be more efficient. Having high volumes of inventory requires a lot of attention to detail and the skills to handle it in an efficient manner. But the most complicated part is keeping track and continuously improving the value of the inventory turnover ratio.

 

One way of doing that is to purchase an inventory management system. Having such a software system is a must for every company. This way, everything  concerning orders, sales and deliveries will be managed in the most efficient manner. Basically, what this system does is to organize the data within a central inventory, so that there will not be any product overstocking or outages. Sometimes, it is associated with distribution, accounting or supply chain software, due to their inherent touch points, because the distributors who have a smaller amount of money held in the inventory are able to compete simply because they have another advantage over their competitors.

 

Such a program has a great variety of features, out of which the most important are:

 

  • Order Management – The feature integrates the ability of reordering a product internally. It also helps the company to avoid placing too much capital in the inventory or to avoid running out of products.

 

 

  • Service Management – This feature can be used by the companies that are more oriented towards delivering services, in order to keep track of cost of the materials they use to deliver the services.

 

  • Product Identification – Barcodes readers can be included in this area, since they are used to scan barcodes, to identify the product and look-up information related to it, such as quantity and location. As technology develops, so does this feature, as the wireless technology and radio frequency identification seem to continuously grow in popularity. 

 

Why Is Inventory Turnover Ratio So Important?

 

In order to answer this question, let’s start with the most obvious reason. A company, regardless of the activity it performs or regardless of the industry it is in, will likely have money tied up in its inventory. By selling the items that are being held in inventory, a company’s money will then be available for paying liabilities, such as employees’ salaries, lenders and the suppliers, and also for investments.

 

The general rule for the inventory turnover ratio goes like this: the higher its value, the more profitable and efficient the firm will be. Basically, if after calculating inventory turnover we discover that its value is high, it means that the company has a low level of average inventory in relation with the sales that have been made. The money that is held up in inventory could face two possible outcomes: it could be borrowed and carry along with it an interest charge, or it could earn some interest if it’s placed in an interest bearing financial asset.

 

The negative aspect of the items that are being held in inventory is that they could deteriorate or, as an example, they could simply go out of style. What could this lead to? In the worst-case scenario, the company’s money could get lost. Then, one should take into consideration the implied costs for maintaining the inventory in storage.

 

Having inventory is a crucial aspect in every company, as it is more than necessary to be able to use it, in order to fulfill and meet the needs of the customers. However, owning too many items in inventory that are not suitable for the profile of the company or for the customers’ needs could lead to some serious financial issues.

 

The inventory turnover ratio is a term that belongs to the accounting field. However, it refers to a measure that shows the number of times inventory is used or sold over a certain period of time, thus making it an important inventory management term as well. It can be found under a wide range of names such as inventory turns, stock turn, merchandise turnover and stock turnover.

 

The days that are included in that period of time, during which the inventory turnover is calculated, can be divided using a specific formula for this concept that would show exactly in how many days the inventory will be sold or it would also show the “inventory turnover days”.

 

But how exactly can this value be determined? There are many formulas out there, but two of them are primarily used. If you make the operation of calculating inventory turnover, you can divide the number of the sales to the inventory. You can also take into consideration the possibility of calculating the inventory turnover ratio by dividing the cost of the goods that have been previously sold to the average inventory.

inventory turnover ratio formulas

Two Inventory Turnover Ratio Calculations: 1) Sales/Inventory and 2) COGS/Avg. Inventory.

 

Calculating the average inventory is a really easy operation to perform. All you need to do is add the beginning inventory to the ending inventory and then divide the number you obtain by two. Otherwise, you could calculate the average days to sell the inventory by dividing the number of the days in a year (365) to the inventory turnover ratio.

calculating average inventory formula

Average Inventory: 1) (Beginning Inventory + Ending Inventory)/2 ; 2) Days in Year/Inventory Turnover Ratio

 

The inventory turnover ratio constitutes an efficient way of displaying the management of inventory by simply comparing the cost of the goods that were sold with the average inventory within a defined period of time. Basically, what this measurement shows, for a better understanding of things, is the number of times a company managed to sell the average inventory dollar amount throughout a year. For instance, a company that has $2,000 of inventory and the value of the sales is of $20,000 has successfully managed to make ten inventory sales.

example calculating inventory turnoverratio

Example: If a company has $2,000 in inventory, and Sales equal $20,000. Then the Inventory Turnover Ratio equals 10.