What is inventory turnover ratio and how do I use the ratio to determine my inventory needs?
The inventory turnover ratio shows the number of times inventory is depleted and replenished over a period of time.
Inventory is generally the largest item on your balance sheet in product sales businesses. Finding the right level of stock to maintain is essential to optimize gross profit and cash flow.
Excessive inventory can cause losses due to selling off at reduced pricing and/or to waste if a product expires. Excess inventory also means cash is tied up unnecessarily.
Too little inventory can reduce your company’s gross profit from lost sales when items are out of stock.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
When calculating the ratio it is important to use data from the same period. So for example, if your company has an average inventory of $500,000 for the year and your cost of goods sold are $1,500,000 for the same year then you sold and replenished your inventory 3 times or in other words “turned it over 3 times” in that year.
It is helpful to know what the industry standards are for turnover for your sector so you can compare your inventory turnover to your competition. Your bank may also compare your inventory turnover to benchmarks when considering whether to extend credit to your business. Year on year comparisons are also recommended to assist you with successful inventory management.
A high turnover means that products are selling rapidly while maintaining correct inventory levels while a low turnover means sales are declining and/or the demand for your product is diminishing. Knowing your customers’ needs is a valuable tool to continue stocking the right inventory levels for your company.
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