How to calculate inventory turnover ratio – what’s good and what’s bad?

What is inventory turnover?

Inventory turnover (also known as stock turnover) is a measure of how well a business manages its inventory.

What is inventory turnover ratio?

Inventory turnover ratio (also known as stock turn) is an accounting and inventory management KPI used to measure how many times stock is sold (used or replaced) within a fixed period of time. It is often used to measure the efficiency of warehouse or stock control processes. The inventory turnover ratio is defined as the ratio of cost of goods sold to the average stock held.

How do I calculate inventory turnover ratio?

The inventory turnover ratio is calculated by taking the total cost of goods sold (COGS) over a specific time period and dividing it by the average inventory value during the same period. Average inventory value is calculated by adding your opening inventory value to your closing inventory value and dividing by 2.

Here’s an example of the inventory turnover calculation:

Let’s look at an example for a company in the building materials industry. The ABC Doors and Windows Company wanted to calculate its inventory turnover for the last 12 months. The cost of goods sold over this period was £815,000. At the end of this period, the stock was valued at £163,000 and the opening value was £140,000.

Using the inventory turnover calculation we get 5.4 turns per annum:

To calculate the average number of days it takes to turn the stock concerned, we divide 365 days by the 5.4 turns, obtaining the result of 68 days:

The importance of having a good inventory turnover ratio

Most stock-holding businesses will have a significant amount of money tied up in inventory. It’s therefore important to keep selling these items and converting the investment back into accessible cash. Using an inventory turnover ratio helps businesses better understand how efficient they are at doing this.

In general, a high stock turnover ratio indicates that a business is managing its inventory effectively. The company isn’t over-buying stock nor is it wasting money on warehousing space. Instead, it’s selling what it buys and it’s bringing cash back into the business to cover the cost of goods sold.

In contrast, companies with a low inventory turnover ratio will often be more inefficient in their replenishment activities. They will see over-stocking of slow-moving inventory and escalating carrying (holding) costs e.g warehouse costs, insurance, utilities etc. Cash will be tied up in inventory for longer and there will be a higher risk of items becoming obsolete with profit margins diminishing as the stock fails to sell.

In summary, a healthy turnover of stock can improve profitability because:

• Items that turn faster have lower carrying costs, positively impacting the bottom line
• Cash is constantly freed-up for reinvestment
• Businesses can remain responsive to the marketplace and react to changes in demand
• There’s less chance of excess stock becoming obsolete and being sold off at a loss

What is a good inventory turnover ratio?

When analysing your stock turnover ratio, remember it will be relative to the stock you sell and the industry you trade in. For example, an ideal stock turnover ratio for a fast-moving consumer goods retailer will be much higher than a company that sells high-end furniture.

Usually, businesses with low gross margins need to turn their inventory more often, so they can offset their low per unit profit with higher sales volumes.

Ideally you’d look to benchmark your turnover against similar businesses in your industry, but if this proves challenging, then look internally at your trends and seek to better them.

However, there is a fine line between having a high inventory turnover ratio and running out of stock! Having insufficient inventory levels can lead to lost sales opportunities, unhappy customers and a damaged reputation over time.

So how do you optimise your inventory turnover rates?

Optimising inventory turnover

If you search the internet you’ll find a number of blog posts and articles telling you that to improve inventory turnover you need to reduce your order quantities e.g order less, more often. But how do you do this without risking stockouts? And do you have the inventory replenishment planning infrastructure and supplier flexibility in order to do so?

The key is to stock the right amounts of the right type of products at the right time. This is because every item in your warehouse is different – they will cost different amounts to sell, they will have different demand patterns, and they will be affected by the time of year, market trends and promotions in different ways.