Inventory turnover ratio

10 financial concepts you should master

Here is lesson five in unwrapping essential financial concepts and how they will help you run your business.

Inventory turnover ratio

This ratio compares the costs in inventory (or stock) to the cost of goods sold. The formula is total sales divided by average stock on hand.

Let us assume for a moment that your business sells boats. You have $4 million in sales and $2 million of boats in stock. That gives you have a turnover ratio of 2.

There is no ideal ratio because it depends on the industry. Many retailers work on having a ratio as close to six as possible, although the higher this ratio is the less cash you have invested in inventory and the more cash you can have on hand or offset against the overdraft. For example, a retailer with a ratio of 6 would have to be generating $12 million of sales versus $2 million of stock.

Accountants say one of the problems with inventory turnover ratios is that it only tells you the average number of times per year that a company’s inventory has been sold. Some items sell faster than others.

As a rule a high inventory ratio means the company is being efficient in managing and selling its inventory. Selling inventory faster ensures that the company has less funds tied up in stock sitting out the back.

Companies with low inventory turnover ratio run the risk that they are holding obsolete inventory which is difficult to sell, eating into the company’s profit.

That said, it really depends on the industry and the business. A manufacturer, for example, might be holding a lot of inventory in anticipation of the holiday season or preparing for a strike among its suppliers.

It is crucial for a business owner to understand why the inventory turnover ratio is high or low. A company’s inventory turnover ratio should be compared to its previous ratios and the industry average.

It can even be worth looking at individual lines of inventory to understand where excess cash might be tied up. Once an item is in stock for a certain amount of time the company might have a sale on that item to keep the cash conversion quicker.

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