For many businesses, funds that are invested in inventory consume a large amount of their working capital. Therefore, it’s important for owners to calculate and monitor their inventory turnover. But, what is inventory turnover and how do you calculate it?
Well, first, inventory turnover is a ratio that measures the number of times a business replaces its inventory in a given period (i.e. how fast a company is moving its products).
How Is Inventory Turnover Calculated?
And second, if you’re wondering how to calculate inventory turnover, follow this formula:
Inventory Turnover = Cost of Goods Sold divided by Average Inventory
Suppose your company had $1,200,000 in cost of goods sold for one year, and your average inventory for the year was $200,000. Following the above formula ($1,200,000/$200,000), your inventory turnover would be six times per year.
What Is a Good Inventory Turnover Ratio?
There’s no single ideal inventory turnover ratio figure; it varies by industry. Companies selling low-priced products with low-profit margins, like grocery stores, tend to have higher inventory turnovers — sometimes up to 30 or 40 times per year.
Meanwhile, businesses that sell more expensive items, such as furniture retailers, will have lower inventory turnovers — maybe only three to four times per year.
A slow turnover could suggest weak sales or that your business has too much inventory. Carrying too much inventory ties up cash and increases carrying costs, such as labor handling wages, rent, property taxes, utilities and insurance. In addition, you may have to offer discounts to get rid of slow-moving and unsold items.
Conversely, a high turnover could indicate strong sales or low inventory. However, not having enough inventory could result in missed sales due to out-of-stock items and lost customers to competitors.
What Is Inventory Turnover Used For?
The inventory turnover ratio is an effort to find the happy medium between too much inventory and too little. Tracking this figure will help you strategically schedule your inventory purchases, possibly arrange financing for those purchases (if needed) and keep a pulse on the financial health of your business.