How to Calculate Inventory Turnover and Improve Your Business’s Cash Flow

30/11/2023

Find out how long your products stay in stock and create a fitting strategy

Topics Covered in this Article:

  1. What is inventory turnover?
  2. Why calculate inventory turnover?
  3. How to calculate inventory turnover ratio
  4. What is the right inventory turnover ratio?
  5. How to enhance inventory turnover
  6. Manage your inventory with Erplain

What is inventory turnover?

Inventory turnover is a concept used in management and accounting to measure how often a company buys and sells its products or goods over a given period. This allows for determining the speed at which stored items are used, sold, or replaced. It is a crucial evaluation of a company's performance in inventory and supply chain management.

A high turnover ratio indicates that stocks are replenished quickly, indicating good collaboration with suppliers and an effective response to customer demand. Conversely, a low ratio can lead to issues of expiration or overstocking.

Why calculate inventory turnover?

Through inventory turnover, you gauge the efficiency of your inventory management by assessing how often products are sold or used. It is, therefore, a vital indicator for maintaining a balance between supply and demand while minimizing storage-related costs.

By calculating your inventory turnover ratio, you can improve three important aspects for your business:

  1. Make smarter purchasing decisions: Products that linger in your warehouse generate no profit. To minimize storage duration, it is crucial to measure the average time products stay in your warehouse before they are shipped to customers. By identifying high-turnover products, you can orient your purchasing policy and adjust production and supply strategies.
  2. Keep merchandise in motion: This is particularly important for distributors and wholesale companies selling perishable goods, such as food items. Failing to calculate your inventory turnover ratio may leave you with cash frozen in unsold products.
  3. Boost sales of flagship products: When the inventory turnover ratio is associated with an inventory and sales management software, it becomes a valuable tool to identify your best-selling items with unprecedented precision.

Inventory turnover plays a key role in calculating Working Capital Requirement (WCR) as it helps estimate the company's ability to manage its supply cycles, thereby maintaining a healthy cash flow. Moreover, a high inventory turnover spreads fixed costs over a greater number of goods, which can enhance profitability.

You can also use the inventory turnover ratio to understand your company's performance relative to your industry.

How to calculate inventory turnover ratio

Inventory turnover is calculated in the form of a ratio, and there are two methods to do so.

Method 1: Formula of inventory turnover ratio based on revenue

This method is currently the most widely used.

  • The 'average stock at selling price' corresponds to the value of the selling price of the products.

Example

Let’s say your distribution company purchased $150,000 worth of products last year and sold them for $200,000 during the same period.

The beginning-of-year stock is $60,000, and it is $40,000 at the end of the year.

The average stock shall be ($60,000 + $40,000) / 2 = $50,000.

Inventory Turnover Ratio:

$150,000 / $50,000 = 3

According to this method based on the cost of goods sold, the inventory turnover ratio is 3. This means that stocks are reordered 3 times during the fiscal year.

Method 2: Formula of inventory turnover ratio based on the cost of goods

  • If you manufacture the products you sell, use the 'Cost of Goods Sold', which includes expenses related to raw materials, labor, and depreciation.
  • If you purchase products to resell, use the 'Cost of Goods Purchased'.

Calculation of average stock value

The average stock corresponds to the average value of a company's stocks over a given period (a month, a quarter, a semester, a year, etc.). If you use an inventory management software, you can easily have it calculated.

There are two main ways to calculate the average stock value:

  • The simplest method is to add the beginning-of-year stock to the end-of-year stock and then divide it by two: (beginning-of-year stock + end-of-year stock) ÷ 2.
  • The most accurate method involves adding the beginning-of-month stock for each month to the end-of-month stock for the last month, then dividing by 13.

At first glance, one might think that both methods yield the same result: your annual sales do not change when calculated on a monthly basis. However, every business experiences monthly fluctuations in sales and stocks. The monthly average ensures that these fluctuations are considered in your calculation and is, therefore, more accurate.

For instance, if you sell more items in summer than in winter, the monthly stock calculation will more faithfully reflect the final result. Think of it as a high-resolution image of your company's finances.  

What is the right inventory turnover ratio?

The optimal inventory turnover ratio typically ranges from 2 to 4 for most e-commerce businesses. However, it can vary based on the industry, the seasonality of the business, cost structure, strategic priorities, operating cycle duration, and product lifecycle. A ratio lower than or equal to 1 indicates an excess of stock.

You should compare your inventory turnover ratio to the industry average to determine if it's faster (higher) or slower (lower) than your competitors.

  • A high inventory turnover implies products being sold at a fast rate, which can be a positive sign, indicating the company doesn't accumulate unnecessary or obsolete items. This reduces merchandise storage costs, requires less storage space, and lowers the risk of holding obsolete or expired products. However, the risk of stockouts is higher, and delivery costs may increase without an appropriate logistics strategy.
  • A low inventory turnover may indicate inefficient inventory management, high storage costs, and risks of obsolescence, requiring a larger warehouse due to a higher stock level, potentially leading to overstocking. However, this can protect your business from stockouts during periods of high demand. Delivery costs are generally lower, but only if the products sold do not expire or become obsolete over time.

The longer a product stays in stock, the more overhead you end up spending on it. Storage costs tend to remain relatively stable from year to year, but your stock levels change – and unfortunately, you can't increase the selling price of an old product to cover the cost of storing it for five years.

Therefore, most entrepreneurs aim for a high inventory turnover and implement measures to reduce the risk of stockouts and logistical expenses.

Stock management

How to enhance inventory turnover

To enhance your inventory turnover, there are various solutions depending on your situation.

Strategies to accelerate inventory turnover

For a higher inventory turnover, it is necessary to reduce orders and/or increase sales.

  • Implement promotions: Stimulate sales and reduce stock quantities by introducing offers, discounts, or favorable prices. This helps to turn over products faster while fostering customer loyalty.
  • Restock less frequently and in smaller quantities: Instead of purchasing stocks for an entire year, buy smaller quantities to meet monthly demand, reducing risks and preventing investment in unsold products.
  • Negotiate discounts with suppliers: If you maintain good relationships with your suppliers, consider negotiating reduced prices. This can lower your purchasing costs, allowing you to offer more competitive prices.
  • Encourage pre-orders: Pre-orders can be an effective way to forecast demand, generate excitement, and collect funds before products are available.
  • Adopt a strategy close to Just-in-Time (JIT): This technique involves receiving products only when they need to be shipped to customers. This limits the costs associated with storing unsold products.

Solutions to decrease inventory turnover

For a slower inventory turnover, you either need to order more goods to stock in your warehouse or decrease sales (a less likely alternative).

  • Analyze your monthly sales and stock data to proactively prepare for periods of high-volume sales. By predicting the value of stocks you are likely to sell during a busy period, you can order in larger quantities from your suppliers accordingly, planning your orders in advance to avoid stockouts.
  • Use an inventory management software: A specialized software, such as Erplain, can help you analyze your stock in detail. Stock levels update automatically and in real time, allowing you to restock just before selling or shipping. It also provides insights into your turnover and the best-selling products, facilitating better planning.

Recommended reading:

Inventory management: issues, optimization, and methods

Christmas 2020 inventory management: How to deal with unsold stock

The 5 inventory management mistakes small businesses often make

Managing stock on a software

The inventory turnover ratio is an excellent way to determine whether you should increase or decrease your stock, as well as to make decisions regarding your inventory management. Like any metric, it needs to be continuously assessed. Therefore, you must ensure that you can react accordingly. The inventory turnover ratio provides an ongoing insight into your stock performance and can help you adjust your strategy accordingly.

Manage your inventory with Erplain

A specialized inventory management software like Erplain helps you achieve a balanced inventory turnover and adapts to your wholesale, distribution, or import-export business, providing accurate data for your sales and stocks. Erplain combines a set of features with an intuitive interface that facilitates the calculation of the inventory turnover ratio.

Try for free!

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