Inventory turnover ratio

The inventory turnover ratio measures the number of times inventory has been sold and replaced, that is, turned over in a given period of time. This ratio is a good indicator of inventory quality (whether the inventory is obsolete or not), efficient buying practices and inventory management.

Inventory turnover can also be called stock turnover, merchandise turnover, inventory turns and, simply, turns.

Assessing your inventory turnover is important because gross profit is earned each time such a turnover occurs.

Measuring how efficiently you’re using your inventory can:

• point to the health and competitiveness of your company
• enable you to see where you might improve your buying practices and inventory management
• help you see if you're missing out on sales opportunities

“Your goal as a business owner is, generally speaking, to turn inventory into cash—the quicker the better,” says Alexandre Barros, a business advisor with expertise in financial management and controls at BDC Advisory Services.

How do you calculate the inventory turnover ratio?

The standard method for calculating inventory turnover ratio involves selecting from your balance sheet the cost of goods sold (COGS) and dividing it by your average inventory value.

COGS is the total of direct costs—things like raw materials and labour—to produce the goods you sell.

When measuring the inventory turnover ratio, average the inventory so that it minimizes the effects of seasonal sales items (e.g., snowblowers, barbecue grills), which can skew your calculation. Businesses typically take two or more time periods and average them out.

Average inventory is calculated using this formula:

Example of inventory turnover ratio calculation

Let's assume that ABC Co. had an opening inventory of $80,000 and a closing inventory of $120,000 during the given period (usually a year). Let's further assume that ABC Co. had COGS of $500,000 for the period.

You would first start by calculating the average inventory as follows:

Now that we have the average inventory, we can proceed with the calculation of the inventory turnover ratio:

This means that the company has turned over its inventory five times during the given period. A high inventory turnover ratio indicates that a company is selling its products quickly and efficiently, while a low inventory turnover ratio suggests that a company may be experiencing slow sales, overstocking, or other inventory management issues.

How  do you  calculate the inventory turnover ratio in days?

With your turnover ratio calculated, it’s easy to figure out the average number of days it takes to sell an item. To do that, you can use the days sales of inventory (DSI) ratio, also known as days sales in inventory or inventory days on hand.

For example, if your turnover ratio is six for a one-year period (365 days), then it takes almost 61 days on average to sell your product. This figure can guide your purchasing as you restock inventory.

With the days sales of inventory figure in mind, says Barros, “you can manage inventory, item by item, and know exactly which products turn into cash more quickly, so you can focus more on products that have higher sales or higher margins.”

Why is the inventory turnover ratio important?

Monitoring the inventory turnover ratio helps businesses make better decisions.

For example, if you analyze your purchasing patterns as well as those of your clients, you could find ways to minimize the amount of inventory on hand. You could turn some of your obsolete inventory into cash by selling it off at a discount to specific clients.

How to improve your inventory turnover

If your turnover ratio is lower than the benchmark for your industry, you should be asking yourself some questions about your company:

Marketing—Are customers buying less? Are we offering the right product mix? Should we change our offer for future sales? Should we invest more in promotions to support sales?

Pricing—Is our pricing too high? Should we discount some products or bundle them to clear out some stock?

Sales—Are our salespeople performing below par? Should we provide missing tools or training for our inventory turnover ratio?

Supply chain—Have supply chain delays, shortages or lack of visibility partly led to this?

Operations—Are manufacturing lead times or delays responsible for this ratio? Should we reduce production or purchasing?

The answers to these questions will have a significant impact on the health of your business.

How to find inventory ratio benchmarks

“It’s important to compare turnover ratios within the same industry,” says Barros. “If you're selling laptops, they’ll probably sell more quickly than if you’re selling high-end cars, which typically sit in inventory longer.”

Industry benchmarks can be found in an online search or in databases managed by industry associations or research firms. Trends for turnover ratios in your own business history can also provide some guidance. Learn more about finding industry benchmarks for your business in this article.

What inventory turnover ratio indicates

A turnover ratio cannot be taken at face value. You need to keep in mind other key performance indicators (KPIs) and the business environment when making decisions.

For example, there may be a strategic business reason for your low turnover ratio. Your company may have deliberately overstocked goods in advance of a product launch, or forecasted a supply shortage, supplier price increase or widespread inflationary pricing.

Generally, slower inventory turns lead to costs increases for businesses.

• Warehousing or holding costs go up since you need to pay rent, transportation and insurance, for each inventory unit.
• Opportunity cost due to slower-moving merchandise hindering the purchase of newer, potentially faster-moving goods.
• Losses in profitability and return on investment (ROI) from having to discount sales to reduce inventory.

Should inventory turnover be high or low?

Businesses aim for a high turnover ratio because it shows strong sales. It also means the business has less capital tied up in goods. When inventory turnover is high, profitability generally improves relative to the company’s fixed costs like salaries and rent.

Furthermore, the decrease in holding costs improves net income, assuming that margins remain unchanged.

If you offer a time-sensitive product, such as food, fashion, and periodicals, then a high turnover ratio is a particularly important indicator.

But very high turnover ratios can also raise questions for your company:

Purchasing—Are we stocking enough goods, and at a fast enough pace? If not, are we losing out on potential sales? Do we need to expand our warehousing capacity?

Supply chain—Are we vulnerable to supplier stockouts due to competitor purchases? Is lack of insight into our supply chain’s capacity hampering our sales potential? Should we add suppliers to our list?

Pricing—Is our pricing right or could we increase it to improve margins?

Include the inventory turnover ratio in your KPI dashboard

Most business owners understand the importance of managing their inventory turnover, says Barros.

“But they wear many hats, working with their team in sales, in operations. They may not dedicate enough time to financials and to ask themselves if they have the tools with the right KPIs to follow up on their financial results.”

Barros finds that many businesses, especially those that earn less than $15 million in annual revenue, fail to use suitable KPIs and monitor them properly with dashboards. Not having these types of controls can leave companies at risk. They may feel they’re in the dark about critical problems and unable to respond to challenges or set goals.

The inventory turnover ratio should be part of a main dashboard of KPIs that owners consult to guide their decisions.

Next step

Improve your company’s cash flow by downloading Inventory Management, a free BDC guide for entrepreneurs.