Understanding inventory turnover ratio and its formula

Do you know what the inventory turnover ratio is? You could be missing out on important insights about your business. This article explains what inventory turnover ratio is, how to calculate inventory turnover ratio, and why it is important.

What is the inventory turnover ratio?

The inventory turnover ratio indicates how quickly a company turns over its inventory in a given period. In other words, it indicates how quickly your company transformed current inventory in sales.

The inventory has to strike a balance between sales and frequency or reorder. Meaning that you should not overstock, which may lead to losses, at the same time you do not have to reorder frequently.

A higher ratio means that the products are sold quickly in the market. In turn, it results in lower inventory management.

How to calculate the inventory turnover ratio

To calculate the inventory turnover ratio, you need to have the following information handy:

• Cost of goods sold
• Average inventory value

In order to get the average inventory value, the formula is:

Average inventory = (beginning inventory + ending inventory) / 2

Let’s take an example:

If you are a garment manufacturer and the business’s COGS by the end of the year is ₹1.5 crore.

You started the year with inventory worth ₹40lakh and while inventory by the end of the year was ₹35lakh.

Then your average inventory is

Average inventory = (40,00,000 + 35,00,000) / 2

Average inventory= ₹37,50,000

Now, that all the needed figures are ready, the formula for calculating the inventory turnover ratio needs to be applied:

Inventory turnover ratio =1,50,00,000 / 37,50,000

Inventory turnover ratio = 4

It means that the said garment company’s inventory turnover ratio is 4 days.

Note: Inventory turnover ratio can be calculated for any period such as quarterly, half-yearly, or annually.

Inventory turnover ratio can be drastically different for during different seasons for some products. This is especially true in the case of seasonal items such as sweaters, umbrellas, festive decoration items, and so on. While some products have relatively more demand in certain seasons such as fans, sunglasses, etc.

What does the inventory turnover ratio indicate?

Calculating the inventory turnover ratio is important for your business as it indicates how well your company handles inventory. Here is how:

• A low inventory turnover ratio indicates problems such as overstocking, weak sales, etc. It can also indicate a lack of marketing efforts by the company.
• On the other hand, a higher inventory turnover ratio indicates strong sales and demand for your products. However, you need to be cautious as it can also indicate a problem of insufficient stocking. You need to ensure that you have enough inventory to support strong sales.
• Although it is not recommended to maintain a low inventory turnover ratio, it is advantageous to do so during the period of disruptions such as inflation, supply chain disruptions, etc. For example, during the lockdown period, retailers struggled to meet demand for essential products, while retailers have more stock could sustain for a longer time.
• If the inventory ratio is to be calculated product-wise, reducing the inventory turnover ratio can indicate decreasing demand. It can help manufacturers to stop/reduce the production of a particular model.

How to improve the inventory turnover ratio?

If your inventory turnover ratio is less as compared to the industry standards, you can take the following actions.:

• Analyse the problem. For example, if your ratio is low inventory ratio can indicate overstocking or low sales or lack of marketing efforts, etc. You first need to find out the cause of the problem.
• Review your strategies related to the problem. If the cause of the problem is a lack of effective marketing strategies, then it is worth reviewing your marketing and branding plan.
• You can deploy software solutions such as an inventory management system to stock enough and maximise sales. This will also help you to improve the accuracy of demand forecasting.
• Prioritise your inventory and adopt efficient reordering strategy.

Frequently asked questions (FAQs)

Author: Swati Deshpande

Swati is a passionate content writer with more than 10 years of experience crafting content for the business and manufacturing sectors, and helping MSMEs (Micro, Small and Medium Enterprises) navigate complexities in steel procurement, and business services. Her clear and informative writing empowers MSMEs to make informed decisions and thrive in the competitive landscape.