Why You Absolutely Need to Know Your Business Inventory Turnover Ratio

Michelle JacoMichelle Jaco12/17/2019


If you're like most businesses, you understand how a lapse in judgment can have dire consequences and lead to lowered profits.

Of these missteps, a common occurrence is failing to implement a surefire inventory management system. Why does this matter?

Because inventory details directly relate to profit, so if you fall short in one area, you're sure to suffer in the other.

But what's the solution?

There's more than one solution to this problem but what every business needs to fix, first, is its inventory turnover ratio.

Inventory Turnover Ratio What Is It?

Knowing how many times inventory is sold and replaced is critical for every inventory-based business. That is what your inventory turnover ratio tells you.

Usually, a high number indicates strong sales, and a low number indicates low sales. But that's not always the full story.

A high inventory turnover ratio can also indicate that your business keeps too little in stock. Contrary to that, a low inventory turnover ratio can indicate that your business keeps way too much in stock.

There are multiple methods of calculating inventory turnover but the most accurate seems to be using the cost of goods sold and average inventory.

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

The average inventory is calculated by taking your inventory at the beginning of the period and at the end of the period, then dividing those by 2.

Keep in mind, having a neat inventory system will make it much easier to do this.


The Optimal Inventory Turnover Ratio for Your Business

Generally, businesses like to be on the safe side and have less inventory in stock. If you're a restaurant, this minimizes the risk of throwing out produce because it expired. If you're a technology retailer, this minimizes the risk of a product becoming obsolete.

But there are risks to both high and low inventory turnover, and depending on your business, one of them might prove a higher risk.

For example, a food truck that only sells burgers might lose a lot of customers if it runs out of stock. But a restaurant that has a wide menu can serve alternatives to the food they don't have in stock at the moment.

Overstocking is usually much more dangerous in any size restaurant. It's especially bad in the foodservice industry because having expired produce is basically throwing money in the trash.

You can sometimes see businesses offer ridiculous discounts, and overstocking might be the reason why. If you have products that are about to expire, it's better to sell them with minimal profit, instead of no profit at all.

Ultimately, determining your inventory turnover ratio will increase profits and reduce waste.

Finding the Magic Number

The best way to find your optimal inventory turnover ratio is by using your inventory management system to generate reports. You'll then need to find out which products sell the most because you should never risk understocking those supplies.

But that's not all.

There are many things that will influence your magic number, like the way you form your ordering habits.

Some businesses might be better off ordering smaller amounts more frequently. This would benefit restaurants because they need to prevent food from expiring but it wouldn't really benefit a laptop retailer.

Comparing your inventory turnover ratio to other similar companies is also beneficial because you can see how they're succeeding or failing, however, that's not always the whole story.

A company that ships its products will have vastly different numbers when compared to a company whose orders ship their products directly from the supplier.

All in all, you'll need to frequently evaluate your inventory and performance numbers. This can be easily done when implementing a strong inventory system into your practices and can make your life a lot easier.


Consider the Circumstances

Even though the inventory turnover ratio can help you increase your profits, it's important to consider the circumstances. What does this mean?

Calculating inventory turnover for a small period such as 3 months will usually show much less than calculating it for a 12-month period. The reason for this is that it's simply too small to show the full picture.

In this case, simply taking into consideration the season will show you a much more complete picture. For example, in the summer, you might have increased evening sales because students have more free time to dine out. Contrary to that, during the school season, you might have more mid-day traffic, for lunch, in between classes.

With a rapidly growing business, there's a lot of chaos, and financial evaluations might be pushed aside. In this case, the metrics need to be analyzed even more often.

If a high-growing company doesn't evaluate performance and inventory metrics every month, they run a high risk of understocking the next month which might make them lose profits.

A high growing company constantly needs to increase the inventory but also needs to take into consideration the orders and back-orders. Dealing with rapid growth is much easier if there's an inventory system in place to lower the workload and reduce mistakes.

How to Improve Your Inventory Turnover

Depending on your business, there are different ways to improve your turnover ratio. Here are some ways that can benefit most businesses

If you keep evaluating performance and inventory metrics on a regular basis, you'll find the right number eventually. There's no easy way to do this but you have to persist and keep improving each month.

Keep in mind that improving your inventory turnover ratio is one of the most important things for your business. Generating reports through your inventory system will make your job much easier to do.

In closing, knowing your inventory turnover ratio is the first step to improving your business and racking in more profits without increasing the workload. If done right, you'll actually be reducing the workload because you'll be spending less time sorting out through inventory-related problems.

Comparing your number with industry-average inventory turnover can give you a number that you might want to aim for. But you still need to do your own calculations and adjust for your business model, industry-average numbers will never be 100% accurate for your business.

Lastly, using an inventory system will remove a lot of the handwork, and reduce the chance of errors occurring.