Unraveling the Mysteries of Your Inventory Turnover Ratio

Many small business owners live and die by inventory. If you’re not moving inventory, then you can’t bring in enough money to stay in operation. If you experience sales success but are unable to replenish your inventory fast enough, you’ll also suffer financially. Therefore, you should strive for a healthy inventory balance that continually restocks what’s going out your door.

Your inventory turnover ratio reveals how well your inventory is working for you and illuminates many of the nuances of this balance. In a nutshell, this ratio illustrates the rate at which you’re replacing inventory during a certain time period. This calculation provides clarity in managing your inventory levels—it also enables you to be more strategic in your pricing, advertising, and purchasing.

“The inventory turnover ratio is an important financial ratio for many companies,” explains The Balance Small Business. “Of all the asset-management ratios, it gives the business owner some of the most important financial information by showing how many times the company turns its inventory over within the given period. The inventory turnover ratio measures the efficiency of the business in managing and selling its inventory in a timely manner. This ratio gauges the liquidity of the firm’s inventory and also helps the business owners determine how they can increase sales through inventory control.”

Do you know how well your inventory is working for you? It doesn’t matter if you sell mixed nuts, pencil sharpeners, fishbowls, or mouse pads, you need to understand the end result of all your small business efforts.

To calculate your inventory turnover, start by identifying the total cost of goods sold by using the annual income statement for your business. Next, add the beginning and ending inventory balances for the month in question, then divide the sum by 2. This gives you the average inventory. Finally, divide your total cost of goods sold by your business’s average inventory.

Congratulations! You’re now the proud owner of your inventory turnover ratio. A high turnover generally stems from high demand. It suggests that you are bringing in a good level of inventory, resulting in fewer costs associated with storage. Because you’re systematically moving inventory out your door, the corresponding sales will boost your cash reserves.

A low inventory turnover ratio isn’t the end of the world, but it could mean you have issues with overstocking. Other possible culprits include ineffective marketing, product line deficiencies, or sales-process problems. The longer your products linger, the less they’re worth to you. And static inventory also means you won’t have as much cash available when needed.

You might be wondering what determines if an inventory turnover ratio is considered high or low. There’s plenty of variation involved, depending on your industry, sales funnel, and other factors. But if you multiply your inventory turnover by your gross margin (expressed as a percentage) and get a result that’s 100% or above, you’re probably in good shape.

As you strive to increase your inventory turnover ratio, you’ll likely see profitability follow a similar trend. Here are some strategies that can help you to achieve it:

• Remove the dross: There are items in your current inventory that probably aren’t selling well. By removing them from your lineup, you can improve your efficiency and save money.
• Double down on the winners: You also probably have inventory that moves particularly fast. Make sure you always have these products on hand and ready to sell.
• Market your winners: Take the time to learn why certain products outperform others. Then use these learnings to advertise them to your customers.
• Look for supply chain breakdowns: Even a fast-moving product will languish if you aren’t able to acquire it consistently. Frequently examine your supply chain to find areas for improvement.
• Lower your supplier costs: It never hurts to ask for discounts from your suppliers. This is particularly true if you’ve worked with them for a long period of time and you consistently place large orders.
• Use the preorder model: If you make it possible for your customers to preorder certain products, you’ll be in a better position to forecast your sales. This allows you to manage your inventory more effectively.
  

Even when you’re running a smooth operation and have mastered all the strategies on this list, your inventory turnover ratio can still drop. One of the largest external factors is the economic climate. As reported by the Associated Press, “the American economy shrank at an annual pace of 32.9% from April through June [2020], by far the worst quarter on record.”

Regardless of where your inventory turnover ratio currently stands, you should recommit yourself to evaluating it consistently to look for areas of improvement. The economy is likely to rebound later this year—put yourself in a prime position to ride the wave and increase your profitability through effective inventory movement.