Mastering the inventory turnover ratio: Tips for better management

The inventory turnover ratio measures a company’s inventory turnover over a specific period, usually one fiscal year. Using this ratio, the company can divide the number of days in the period to determine how long it takes to sell inventory. This calculation is useful for retail companies, as it helps assess stock pricing, purchasing, and business management strategies.

Key takeaways

• Inventory turnover ratios measure the efficiency with which a company sells and restocks inventory within a specified time.
• A high inventory turnover ratio may mean the business is doing well, selling products quickly, and managing inventory effectively.
• A lower inventory turnover ratio may indicate poor sales, excessive inventory in stock, or problems in marketing or merchandising. 
• Businesses should regularly assess their inventory management processes to lower holding costs and improve profitability.
• Software solutions make monitoring inventory and interpreting the information gained through inventory turnover ratios easier.

Table of contents

• What is inventory management?
• Understanding inventory turnover
• Important inventory metrics
• Interpreting inventory turnover results
• Factors affecting inventory turnover
• Tips for improving inventory management
• Using financial statements for inventory management
• Avoiding common mistakes 
• Industry benchmarks
• Calculating inventory turnover
• The benefits of a higher inventory turnover
• Inventory management strategies
• Use FreshBooks to help calculate inventory turnover ratios

Inventory turnover ratios are one of many important metrics to consider when running your business, giving you insights into sales, and providing tools to use for future planning. Interpreting the data found using the inventory turnover ratio is complex, but can be made easier with specialized inventory management software solutions. 

In this article, we’ll explore inventory management, turnover, and strategies in greater detail, we’ll look at common mistakes companies make, and offer tips for improving inventory management. 

What is inventory management?

Inventory management controls the amount of goods a business has for sale or uses in production. Depending on the company, this may mean finished goods, raw materials, or goods used during production. 

Some key aspects of managing inventory include tracking stock levels, identifying shortages or overstock, managing storage or warehouse space, and calculating and interpreting inventory turnover ratios to make informed decisions. It also involves monitoring customer demands to appropriately adjust inventory purchases depending on sales forecasting and data interpretation.

Effective inventory management improves business performance, making sure the business has enough inventory to meet customer demand while avoiding excessive inventory holding and minimizing waste, storage, and overstocking costs. 

Understanding inventory turnover

Inventory turnover refers to the number of times a company sells and replaces its inventory within a given period. 

Using the inventory turnover ratio, the company can measure how well it generates sales from its inventory. A higher ratio generally indicates strong sales and efficient inventory management, while a low inventory turnover ratio shows that improvements are needed. Maintaining a good merchandise turnover ratio is essential for maintaining operational efficiency while maximizing potential sales opportunities.

Important inventory metrics

Important inventory metrics include turnover rates (how quickly inventory is sold and restocked during a certain period), inventory storage costs (including insurance, rent, handling costs, etc.), and the time it takes to order and receive stock. 

Interpreting inventory turnover results

If a company has a low inventory turnover ratio, it may indicate weak sales, excessive inventory, or poor inventory management, while a high inventory turnover ratio might indicate strong sales, or it might also mean there’s insufficient inventory available for sale. The ratio will also be affected by holding and storage costs, and your overall inventory management capabilities.

When interpreting inventory turnover results, it’s important to consider industry benchmarks, or what is considered “good” in your specific industry. You must also look at company-specific factors like inventory valuation in your business, as well as overall industry trends.

Factors affecting inventory turnover

Some of the most common factors affecting inventory turnover include:

1. Consumer demand

Customer demand is an important factor in how quickly an item is sold. When demand is high, turnover is faster, and when demand is low, products will remain on the shelves or in storage longer. Companies should regularly check inventory levels, adjusting strategies to ensure there’s enough product to consistently meet customer demand and improve sales opportunities.

2. Seasonal fluctuations

In some markets, demand changes depending on the season. In times of peak demand, sales will increase, leading to higher turnover, and in the off-season, demand drops, resulting in fewer sales and lower turnover.

3. Supply chain efficiency

An efficient supply chain will ensure products are available for the consumer without delay. If there are supply chain issues, the inventory turnover will decrease, as product replenishment will slow, meaning fewer products will be on the shelves for customers to purchase.

4. Sales channels

Sales channels are the pathways or methods a business uses to sell their products to consumers. This may include physical stores, online sales, or using a distributor. When these channels are interrupted, or a business hasn’t reordered stock in time, then the inventory can’t be sold to the customer, leading to a lower turnover ratio. 

5. Management strategies

There are several ways in which a good inventory management strategy will positively influence turnover. These include:

• Demand forecasting
• Optimal pricing
• Marketing
• Streamlining ordering processes
• Optimizing stock levels
• Ensuring efficient supplier relationships

Companies with low inventory turnover may need to reassess their inventory management strategies and replenishment policies to upgrade their efficiency and profitability.

Tips for improving inventory management

To improve inventory management, companies should calculate inventory turnover regularly, and take time to analyze the results thoroughly. Implementing effective inventory management strategies, like just-in-time inventory management, can help optimize inventory levels. Inventory management software will further simplify the process, streamlining operations and enhancing efficiency. 

Using financial statements for inventory management

A business’s financial statements provide essential data for calculating inventory turnover ratios, like the cost of goods sold (found on the income statement) and the ending inventory balance (found on the balance sheet). 

By analyzing these financial statements, small business owners get more than just an overview of their company’s financial health and performance. It’s also an essential step in identifying areas for improvement in the company’s inventory management processes. 

Avoiding common mistakes

Some of the most common mistakes to avoid with inventory management include:

1. Not monitoring inventory levels

Failing to monitor inventory levels may hinder future demand predictions, which may result in wasted resources and impact the business’s profitability.

Overstocking with excessive inventory ties up working capital, makes organization difficult, and increases the need for storage space. Depending on the product, stock may also expire or become obsolete if held too long in storage. Alternatively, understocking with inadequate inventory on hand might lead to issues like dissatisfied customers and lost sales. 

To avoid inventory level issues, companies should regularly monitor stock levels and adjust their inventory management strategies accordingly. 

2. Failing to account for consumer demand

Consumer demand is the term for the amount of product customers are willing to purchase in a given period, and at what price. If a business has a low turnover ratio, it may be because they haven’t considered market demand for the items it’s selling. 

3. Remaining inflexible with management strategies

Switching management strategies and adapting to changing markets will maximize a company’s ability to lower costs, stay relevant, avoid carrying obsolete inventory, and prevent over- or under-stocking. A flexible inventory management system allows for market fluctuations, supply chain disruption, and changes in consumer demand, adapting to changes to ensure a manageable amount of inventory is available at all times. 

4. Ignoring industry benchmarks and company-specific factors

Failing to consider unique industry norms, seasonal fluctuations, and company-specific factors like return rates and supply chain issues can also lead to inaccurate interpretations of inventory turnover results. For example, low-margin industries tend to have higher inventory turnover ratios than high-margin industries.

Industry benchmarks

An industry benchmark can also be called the industry standard. This metric is used to help businesses in the same industry measure their profitability, assess their performance, and check their business practices against similar businesses and competitors. Industry benchmarks also help with identifying areas for improvement, setting realistic goals, and tracking progress.

Benchmarks are important to factor in when analyzing inventory turnover rates. The norms vary widely between industries, but a good inventory turnover ratio is generally considered to be between 4 and 6. 

Calculating inventory turnover

To calculate the inventory turnover ratio, you need to know the cost of goods sold (COGS) and the average inventory value.

The following formula will help you find the COGS:

(Beginning Inventory + Purchases) – Ending Inventory = COGS

You must first determine the cost of the goods available for sale by adding up the inventory you’re starting with and what the company has purchased during the specified period. From that number, subtract the inventory remaining after that same period has completed, and that’s your cost of goods sold. 

You’ll find the average inventory amount by adding the beginning and ending inventory balances, then dividing that number by 2. 

To calculate the company’s inventory turnover, you then use this inventory turnover formula: 

Cost of Goods Sold (COGS) ÷ Average Inventory = Inventory Turnover Ratio

Using an inventory turnover ratio calculator will simplify the calculation process. 

The benefits of a higher inventory turnover 

A good inventory turnover ratio may mean the company has a competitive advantage in its industry, with robust sales and an efficient inventory management system. Some benefits of having a higher inventory turnover include more potential sales, reduced inventory holding costs, and efficient operations with frequent inventory replenishment.

Inventory management strategies

Effective inventory management strategies are systems put into place to plan, control, and monitor the company’s inventory levels. This may include strategies like just-in-time inventory management, inventory optimization, and supply chain management.

It’s important that businesses regularly review and adjust these strategies to ensure they meet customer demand while minimizing costs. Using inventory management software can streamline processes while improving operational efficiency. 

Supply chain efficiency

Supply chain efficiency is when a business minimizes logistical costs and maximizes profits using a combination of expertise, resources, and available technology to source, order, and receive products. It’s an important factor for companies to ensure they can meet customer demand and minimize inventory holding costs. 

Companies need to review and optimize processes regularly. By looking at inventory turnover ratios, companies can identify areas for improvement in their supply chain management processes.

Inventory management software

Using inventory management software with tracking, automated reporting, and supply chain management can help companies streamline their inventory management processes and improve operational efficiency. 

Businesses of any size benefit from implementing inventory management software to optimize inventory management processes. It reduces errors and gives instant access and easy visibility to all unsold inventory to make pricing, ordering, and decision-making easier. 

Use FreshBooks to help calculate inventory turnover ratios

Mastering the inventory turnover ratio and understanding how to interpret its results empowers small business owners to make informed decisions, optimize inventory management, and unlock greater sales potential.

To support these efforts, leveraging accounting software like FreshBooks can make a significant difference. In addition to its powerful invoicing and user-friendly accounting tools, FreshBooks offers simple inventory tracking features that help you stay on top of billable items and streamline your operations. With automated reporting, easy expense tracking, and invoicing on the go, FreshBooks simplifies your workflow—saving you time and improving overall efficiency.
Ready to take control of your inventory and finances? Try FreshBooks free and experience the difference it can make for your business.

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