Inventory Turnover: What is it, a Beginner’s Guide

Your inventory could be an untapped goldmine. Manage it well and you will unlock all the riches you and your Finance Director desire. But only if it’s managed in the right way.

Managed poorly, however, your inventory is nothing more than a big hole in the business where money’s shovelled in, like a steam train using bank notes to run up a mountain.

Supply chain inefficiency will kill your results and your bank balance. So, how can you work your inventory as hard as possible? How can you reap the rewards from every penny you invest? And how do you make sure your inventory makes money, not drains it?

Less is more.

You want the maximum value you can achieve. And crucially, the highest profits you can muster, from the smallest amount of stock.

Therefore, when it comes to inventory levels, less is more.

That’s not an easy quest. To make sure it’s anywhere close to achievable, you need to make every pound you spend count. And that’s why we wrote this article.

Throughout this blog, we’ll tell you everything you need to know about inventory turnover.

We’ll talk about how you can use your inventory turnover to assess efficiency. We’ll delve into what a ‘good’ Inventory turnover rate looks like. And we’ll even explore some practical strategies to make your inventory turnover faster.

Let’s start at the beginning.

What is inventory turnover?

Inventory turnover is a simple ratio. However, this powerful formula can reveal some critical information about the health of your supply chain processes.

Namely:

How many times have you sold and replaced your inventory during a specific period?

You can calculate your rate of inventory turnover by dividing the cost of goods sold by the average inventory value.

Let’s make it easy and logical, and say it’s over a 12 month period.

A higher inventory turnover ratio would indicate a better sales strategy and a more efficient approach to inventory management.

On the other hand, a lower rate of inventory turnover number, or ratio, would show the opposite. Either you need to light a fire in the sales team, or you have excess inventory you can’t shift.

Of course, this is not always the case (and we’ll talk more about this later) but in essence inventory turnover is a very handy ratio indeed. Read on to the next section to find out more.

Now, we could apply the inventory turnover ratio to your entire assortment, individual product categories or even to a specific SKU. Although, it’s important to note that inventory turnover is based on an average.

Why is inventory turnover important?

Being able to get an instant snapshot of your company’s efficiency should always be welcomed. Even if you don’t like the answer. Your inventory turnover rate will give you this picture.

Your inventory turnover can reveal lots of telling things about your business. However, here are 3 of the most important reasons you should utilise the Inventory Turnover formula:

 

Reason number one: Cash flow

You might think having stock in situ, ready and waiting to get sold is a benefit to business. And in some cases, it can be. However, if you are holding more stock than you really need, it might be the opposite.

Afterall, the longer that stock sits in your warehouse, the longer you have to wait until you see your original investment again.

A higher stock turnover rate suggests that your inventory management approach is more effective at converting stock into cash.

And naturally, selling an item in a quicker fashion means you receive the money from that sale faster too. This, in turn, will improve your cash flow, speed up your cash-to-cash cycle and make your Profit & Loss Statement nicer reading.

You’ll have more cash in the bank, be able to spot and take advantage of more growth opportunities and pay off debts faster too, decreasing interest and making things look all the rosier.

Top tip: Check our blog on working capital to find out how you can optimise your investment in stock to improve your ROI and ensure a healthier cash flow.

Reason number two: Cost management

If your inventory turnover rate is low, you might be holding on to too much stock. And that can come with pitfalls aplenty.

Firstly, it’ll tie up your working capital. But it’ll also increase the storage and holding costs. And, if you need more warehouse space, that won’t come cheap.

That’s before we’ve considered the increased risk of losing inventory to obsolescence. Losing revenue because you’ve thrown half your stock in an incinerator really isn’t a good look.

Put simply, the inventory turnover ratio formula can be a handy tool to detect if your supply chain costs are running away.

Top tip: The true cost of holding inventory might surprise you. Discover how you can calculate your supply chain costs and proactively reduce them with our inventory cost cheatsheet.

Reason number three: Risk management

Keeping close tabs on your inventory turnover can also help limit the risk you leave yourself open to. It increases the knowledge you have, and therefore leaves fewer things to chance.

In inventory management that’s a positive. As they say, knowledge is power.

Anywhere you can make an informed decision over a wild stab in the dark will help your business and should be prioritised.

Careful monitoring will help your operations and financial strategy. It’ll highlight areas to improve and provide hints on where to optimise.

And what’s more, by taking steps to continuously improve your stock turn, there will be more money flying about to respond to unexpected disruption as required.

Top tip: Supply chain management is all about managing risk. Sure, disruption is not a new concept. But in recent times, it seems the scale and impact of supply chain shocks has increased exponentially. Find out what steps you can take to mitigate risk with our guide to supply chain resilience.

How can you calculate your inventory turnover?

Inventory turnover is a great way to track efficiency.

However, the formulas to gauge the efficiency of your inventory management, are plentiful. There are several ways of measuring it.

Here are a few of them.

Inventory turnover ratio:

This is the one we’re predominantly talking about today and is a hugely popular way of analysing the success of your inventory optimisation goals.

This ratio, as we mentioned above is a simple measurement: How many times have you sold and replaced your inventory during a specific period?

It’s usually a year but can differ by company.

The formula looks like this:

Inventory Turnover = COGS (Cost of Goods Sold) / Average Inventory Value

If you were to have an inventory turnover rate of 6, you’ve sold and replaced your inventory 6 times during that period. Happy days.

Days inventory outstanding (DIO):

‘Stock days’, ‘inventory on hand’, ‘inventory turnover days’ or the above, ‘days inventory outstanding’ – these all refer to the same calculation.

Days inventory outstanding is another simple formula that measures the average number of day’s worth of inventory you hold.

Naturally, a lower DIO means you’re shifting products out the door quicker, and have fewer days with them being a burden.

That’ll therefore mean you’re more productive and more efficient.

A higher inventory turnover ratio will indicate the opposite.

The way to work out your inventory turnover days formula (or DIO) is:

Average Inventory / Cost of Goods Sold X 365 (for the yearly average).

Gross Margin Return on Investment (GMROI):

There’s a difference in value between what you paid for your stock, and what your customer will buy it for.

At least, hopefully, there is, and it’s in your favour. If not, your business might be in deep trouble.

This difference can be calculated using the Gross Margin Return on Investment (GMROI) ratio.

The way to work this out is:

GMROI = Gross Profit / Average Inventory Cost

A lower number here will suggest you have too much inventory or you’re not selling for a high enough margin. A higher ratio or number is a good sign and it means you’re getting a great ‘bang for your buck’.

Inventory carrying cost ratio:

If you were to add up all the costs of carrying inventory, how much would it total up to? We’re talking the price to buy, store, ship, insure, and cover all of the warehouse operators, overheads, the lot.

This formula will work that out for you.

Inventory Carrying Cost ratio (%) = Total Carrying Costs / Total Inventory Value X 100

If you arrive at a low ratio, it indicates you’ve got an efficient inventory management process. Conversely then, a higher ratio suggests you’re holding too much inventory and that it’s eating up your margins..

Obsolete inventory ratio:

Many of the formulas above can highlight that you may have an excess stock issue. And there are lots of reasons why excess stock is a problem. But what percentage of your inventory can you no longer sell?

To work that out, and analyse how much that’s costing you, use this formula…

Obsolete Inventory Ratio = Value of Inventory Items with No Recent Usage / Total Inventory Book Value.

Whether you define “No recent usage” as no sales in the last 6 months or last year, is up to you.

However, a lower ratio will suggest you’re managing your inventory fairly well and cutting out waste wherever you can. A higher ratio will denote the opposite and highlight a potential problem that needs fixing.

What does a good stock turn look like?

All of the above formulas are useful in their own way.

But for this next part we’ll focus on inventory turnover… given this article’s title.

What ‘good’ looks like in a stock turn will differ depending on what you sell, and the industry you’re in. The general consensus is, ‘good’ is between 4 and 6.

The theory suggests a high inventory turnover ratio means you’re managing inventory efficiently. But it might also suggest you’re not keeping enough to meet the demand at your doorstep.

If you think about FMCG or food companies, the stock turn will be very high. It’s impossible to keep some food products sitting on your shelf for a long time, and therefore a stock must rotate every few days to keep the products fresh.

This will see the stock turnover figures rise well into double figures. But let’s not forget, there is always a high risk of obsolescence.

Compare that with other businesses, like a company that distributes car parts for vintage vehicles and the difference is dramatic. A stock turn here might be 1, or 2.

The pertinent point here is, ‘good’ looks different to all of us.

Your business will have a different idea of ‘good’ to the company at the neighbouring address.

What could impact your company’s stock turn?

The quick answer to this is several things. But let’s look at them all in a little detail.

1. Sales volume:

If you increase your sales, the higher your stock turn ratio will be. Presuming, of course, your inventory levels remain stable.

Higher demand will naturally mean your products are sold quicker and therefore have a higher stock turn ratio than those with slower sales which stay in your warehouse for longer.

2. Inventory levels:

Keeping hold of excess inventory might lower your stock turn ratio. If you’re not selling it, and it remains sat on your warehouse shelves, and on the books, that’s going to impact things.

But once again, this is a balancing act. Being too quick to cut inventory levels may mean you’re not prepared should demand pick up again.

And that will, in turn, affect your ratio as you struggle to meet customer demand.