In an article by Marshall Hargrave in Investopedia, inventory turnover is defined as a ratio showing how many times a company has sold and replaced inventory during a given period. A company can then divide the days in the period by the inventory turnover formula to calculate the days it takes to sell the inventory on hand. Calculating inventory turnover can help businesses make better decisions on pricing, manufacturing, marketing and purchasing new inventory.
Inventory turnover measures how quickly a company can sell inventory and how it compares to industry averages. A low turnover implies weak sales and potential excess inventory, also known as overstocking. It may indicate an issue with the goods being offered for sale or be a result of a weak marketing effort. A high ratio indicates either strong sales or insufficient inventory. Sometimes a low inventory turnover rate is a good thing, such as when prices are expected to rise or when shortages are anticipated.
The speed at which a company can sell inventory is a critical measure of business performance. Retailers that move inventory out faster tend to outperform. The longer an item is stored in the warehouse, the higher its holding cost will be, and the fewer reasons consumers will have to return to the shop for new items.
Joshua Kennon, in an article for The Balance, talks about how the time it takes a company to sell its inventory varies greatly by industry. Retail stores and grocery chains typically have a much higher inventory turn rate since they sell lower-cost products that spoil quickly, requiring far greater managerial diligence.
Companies that manufacture capital equipment, such as yachts, will have a much lower turnover rate since each product may sell for millions of dollars and take extended periods of time to produce and sell. Industrial supply companies may turn their inventory three or four times a year, while clothing stores may turn their inventory six or seven times per year.
The inventory turnover calculation = cost of goods sold for a period of time / average inventory for that same period.
To get an annual number, start with the total cost of goods sold for the fiscal year, then divide that by the average inventory for the same time period. To get the average inventory balance, add the current inventory balance to the previous period’s inventory balance and divide by two.
Inventory turnover is important because a company often has a significant amount of money tied up in its inventory. If the items in inventory do not get sold, the company’s money will not become available to pay its employees, suppliers, lenders, etc.
It is also possible that a company’s inventory will become less in demand or become obsolete. If that occurs some of the company’s money will be lost. Having slow-moving items in inventory also uses valuable space and makes the warehouse less efficient.
Andrew Ruff with TGG Accounting offers sound reasoning for paying close attention to inventory turnover, he says; speed in business references time to customer acquisition, how quickly a project can be completed, how fast collections on invoices happens, or customer response times. All of these “speed measures” are critical to providing the customer with an enhanced experience or to the financial success of a business. However, specific to manufacturing or retail companies, the most critical “speed metric” is often overlooked –Inventory Turnover.
It is critical that Executive Management teams, inventory/warehouse managers, buyers, and marketing teams review and analyze Inventory Turnover Ratios. One of the best methods for reviewing Inventory Turnover Ratios is to track the ratio at a product type or “sku” level and graph the ratio in monthly increments over a trailing 13-month period. Using a trailing 13-month snapshot will assist the business in better understanding seasonality and internal buying cycles. The goal is to move inventory with ever-increasing speed and create a downward trend in the Inventory Turnover Ratio.