Any company that sells physical goods wants to be in a scenario where products are moving quickly or “flying off the shelves.” This means the company efficiently manages its inventory and doesn’t have unsold stock piling up.
The inventory turnover ratio offers businesses an objective measure to monitor this and show how well it generates revenue from inventory. The good news is that finding this metric involves a simple calculation that can be done in just a few steps.
In this guide, we’ll cover the inventory turnover ratio in further detail, including the formula to calculate it and some expert tips to help improve this metric.
What is the inventory turnover ratio?
The inventory turnover ratio is a measure of how many times the company completely sells off its inventory in a given period of time.
It represents the relationship between the cost of goods sold (COGS) and average inventory levels, showing how efficiently the business manages its unsold stock and converts it into sales.
Importance of tracking inventory turnover
Business leaders can monitor the turnover ratio to get a better understanding of how well the team manages and replaces its inventory.
At a basic level, it shows how long it takes the company to sell off all current inventory. From there, the turnover ratio can be used to make important merchandising decisions, including how often to order a restock, which products to carry, how to price items, and when to engage in promotional activities.
Beyond internal decision-making, the inventory turnover ratio can also be used by external stakeholders to compare a company against industry peers. This might be used to inform investment and credit decisions, though it’s typically only effective when compared against businesses in similar lines of business, given seasonal variations and other factors.
Inventory turnover ratio formula
How to calculate Inventory turnover ratio
The formula to calculate the inventory turnover ratio is relatively simple and straightforward, using values already found on the company’s financial statements.
Calculate the ratio with the following formula:
There’s an additional step at the beginning to find the average inventory using the starting and ending balance for the period, as shown on the balance sheet.
Then, divide the COGS value (from the income statement) by this calculated value to find the inventory turnover.
Step-by-step inventory turnover ratio calculation
Step 1: Find beginning and ending inventory
The first step is to identify the beginning and ending inventory values shown on the balance sheet. This is typically the ending inventory balance from the previous and current periods.
For example, to find the inventory turnover ratio over 2024, you’ll need to find the ending inventory balance from both 2023 and 2024. In this case, the ending value for 2023 is considered the “starting” value for 2024.
Step 2: Calculate the average inventory
Using the starting and ending inventory balances, find the average inventory value for the period with the following calculations:
Step 3: Identify the COGS
The next step is to find the cost of goods sold, as reported on the income statement for the period in focus. Using the example from step one, this means you’ll need the COGS from 2024.
You are not concerned about the COGS from the previous year, unlike with the average inventory calculation.
Step 4: Divide the COGS by average inventory
The final step is to use the inventory turnover ratio formula and divide the COGS by the average inventory value.
Inventory turnover ratio example
There’s a local boutique that ended 2023 with an inventory balance of $120,000. At the end of 2024, the business had an inventory balance of $90,000 while also reporting COGS of $260,000 for the year.
To find the inventory turnover ratio for the boutique, we first find the average inventory value with the following calculations:
Avg. inventory = (90,000 + 120,000) / 2
= $210,000 / 2
= $105,000
Already knowing the COGS value from the most recent profit and loss statement, we can find the inventory turnover ratio as:
Inventory turnover ratio = $260,000 / $105,000
= 2.48
In other words, the boutique completely sold off, or “turned over,” its inventory nearly two and a half times during 2024. A lower ratio would indicate slower sales, while a higher value might represent more revenue activity for the year.
Going one step further, the company could determine how long it takes to sell off its inventory by dividing the number of days in the period, which is 365 days in this case, by the turnover ratio. This would look like:
= 365 days / 2.48
= 147.2 days
Thus, the business can expect to sell all of its inventory every 147 days or so. Knowing this value can help the boutique time inventory orders, plan promotional activities, and other related decisions.
Understanding the inventory turnover ratio
What does the inventory turnover ratio indicate about a company, and what is a good value to aim for? Continue reading below as we take a closer look at this metric and what it might mean for retailers.
Factors that affect inventory turnover
As shown above in the inventory turnover formula, there are just a few values that impact this financial metric. This includes:
- Starting and ending inventory: Taken from the balance sheet, the starting and ending inventory balances are used to find the average inventory balance during a given period.
- Cost of goods sold: The cost to purchase and produce the goods sold is used in the formula, as this is typically how inventory is valued.
What is a good inventory turnover ratio?
What’s considered a “good” inventory turnover ratio depends on the specific industry or sector. For example, a store selling luxury goods typically has lower turnover than a discount retailer, simply by the nature of the business.
Companies generally strive for a higher inventory turnover ratio, indicating strong sales activity. On the other hand, a lower ratio indicates that inventory is slow-moving, and the company may not be generating sales as effectively.
However, a very high ratio may point to potential merchandising problems and poor inventory management. For instance, it may reflect that the company doesn’t order enough goods to meet customer demand and consistently sells out of products.
Implications of an inefficient inventory turnover ratio
A company can interpret a low inventory turnover ratio in a few different ways. In general, it indicates the company has slow-moving sales activity.
This might mean it has priced goods improperly for customer demand, and prospective buyers aren’t willing to pay for the item at the current price. Or, it may show that the team has ordered too many units than what the market demand warrants.
What an inventory turnover ratio can tell you?
For both internal and external stakeholders, the inventory turnover ratio provides several important insights about a company’s inventory management practices and overall financial performance, such as:
Insights into sales performance and demand
The inventory turnover ratio doesn’t just show how often a company sells off its inventory; it’s also a good indicator of the business’s general sales activity.
As mentioned throughout, a higher turnover typically indicates greater sales volume, meaning the company is not having issues generating revenue.
But, a lower inventory turnover could mean the team is having a hard time bringing in sales, which may be the case for a number of reasons. Maybe the team isn’t carrying the right items for the target market, they aren’t marketing the goods correctly, the products are out of season, etc.
Identifying slow-moving or obsolete inventory
This metric also helps a company pinpoint items that are particularly hot in the current market and see which items are not as popular.
A lower inventory turnover ratio compared to previous periods might help the company see that its inventory is aging and has become obsolete.
Inventory turnover and dead stock
When discussing inventory turnover and finding strategies to improve this metric, companies might come across the concept of dead stock, which refers to items that have been deemed unlikely to sell.
This is typically inventory that has been sitting on the shelves for an extended period and has become outdated, unusable, or fallen out of favor with customers.
Dead stock can weigh on inventory turnover and be costly to businesses as a portion of their capital remains tied up in unsold merchandise that may never sell.
Strategies to minimize dead stock and improve turnover
If a company recognizes that it has dead stock, it may need to run a promotion and sell the items at a discounted price, donate them, or find another way to dispose of or recycle the goods to make room for in-demand items.
However, there are some strategies to help prevent accumulating dead stock in the first place, like:
- Monitoring customer demand and staying on top of current trends to curate a product line that aligns with the market
- Using an inventory management system to avoid overstocking goods and time orders from suppliers more effectively
- Running promotions to encourage sales of slow-moving items before they become dead stock
- Forecasting sales and customer demand more precisely to inform inventory orders
Related inventory metrics
The turnover ratio isn’t the only metric stakeholders can use to monitor the effectiveness of inventory management.
There are additional inventory metrics that can provide a more comprehensive view of a company’s merchandising activities and sales efficiency. This includes:
- Inventory carrying cost: What it costs a company to manage inventory while in storage
- Order cycle time: How much time it takes the company to fulfill a customer order, on average
- Days inventory outstanding: A measure of how long it takes a company to sell inventory
- Lead time: The amount of time between when a customer submits an order and when they receive the items
- Sell-through rate: The percentage of units received from a supplier that end up getting sold
- Inventory shrinkage: The portion of a company’s inventory that it cannot account for
Streamline financial management with BILL
Optimizing inventory turnover and management is an important facet of building sustainable growth.
However, this can become more difficult to manage as the business scales and expands operations, while also managing other critical financial functions like accounts payable and accounts receivable.
Using an integrated financial management platform, like BILL, can make it easier for teams to create and control budgets, pay suppliers, send invoices, and manage expenses from one convenient location.
Get a demo today to see how BILL can transform your financial operations.
