Understanding Inventory Turnover for Business Success

Written by
Aaron Oh
Published on
February 19, 2024

As a business owner, you know some products will fly off the shelves while others gather dust. And sometimes, it's somewhere in between. That's where knowing how fast things are selling becomes super essential and where the inventory turnover calculation comes in. It's your weapon for setting prices, managing supplier relationships, and deciding when to promote or retire a product.

So, Let’s Understand What Exactly Is Inventory Turnover?

Inventory turnover measures how long a company can sell the items it buys. When all the purchased stock is sold, except for items lost due to damage or shrinkage, one full turnover of inventory occurs.

Successful companies often experience multiple inventory turnovers annually, though the frequency varies depending on the industry and product type. 

Now that you know inventory turnover meaning, let’s look at inventory turnover ratio

What’s An Inventory Turnover Ratio?

A company's inventory turnover ratio tells us how often it has sold and restocked its inventory within a defined timeframe. It can also help determine the days required to sell the existing inventory.

How to Calculate the Inventory Turnover Ratio?

To find this ratio, you divide the cost of goods sold by the average inventory during a certain time. A higher ratio is better because it usually means you sell a lot.

Here’s the Inventory Turnover Ratio Formula

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

The first and most important step to calculate inventory turnover is to manage your inventory well. This is also called stock control. It's all about knowing what inventory you have.

Before we look at an example, let's talk about two important things: the Cost of Goods Sold and Average Inventory.

What is the Cost of Goods Sold (COGS)?

The Cost of Goods Sold, or COGS, represents your company's direct expenses in producing the goods sold within a specific timeframe. These expenses encompass materials, labour, and overhead directly tied to production. Understanding and accurately calculating COGS is essential for determining your company's gross profit and assessing its financial performance.

And What Is Average Inventory?

It's the average value of your inventory over a specific period, typically calculated by adding the beginning and ending inventory balances for that period and then dividing by two. This metric offers insights into your inventory levels and helps you assess how well you manage your stock over time.

Now that you know what they are, let's understand this with an example. 

Inventory Turnover Ratio Example

Consider a manufacturing company based in Singapore, "TechEmitt Ltd.," specialising in producing smart home devices. 

They procure S$2 million worth of raw materials and components annually. 

At the beginning of the accounting period for the year, their inventory stands at S$400,000; by the end, it dwindles to S$300,000.

Now let’s calculate TechEmitt Ltd.'s inventory turnover:

  1. Average Inventory: 

Average‚ÄČInventory = (Beginning‚ÄČInventory + Ending‚ÄČInventory)/2

Average‚ÄČInventory=(S$400,000+S$300,000)/2 = S$350,000

  1. Cost‚ÄČof‚ÄČGoods‚ÄČSold: S$2,000,000
  2. Inventory Turnover Ratio: 

Inventory‚ÄČTurnover Ratio = Cost‚ÄČof‚ÄČGoods‚ÄČSold /Average‚ÄČInventory

Inventory‚ÄČTurnover Ratio = S$2,000,000/S$350,000 ‚Čą 5.71

This example shows that TechEmitt Ltd. manages its inventory well. They sell and replace their smart home devices about 5.71 times a year, which means they use their resources effectively. This suggests they're good at keeping their products moving and keeping them from sitting around too long. It also indicates that there's likely a high demand for their devices, or they're proactive about managing their inventory levels. Overall, it shows that TechEmitt Ltd. runs its business efficiently.

Why Is Inventory Turnover Important? 

Inventory Turnover Ratio helps in - 

  • Assessing Your Business Performance:
  • Understand how quickly your inventory sells.
  • Evaluate how effectively your inventory meets market demand.
  • Compare your sales performance with similar products in the same category.
  • Importance of Inventory Turnover:
  • Higher turnover indicates the marketability of your products.
  • Reduces your holding costs like rent, utilities, insurance, and theft.
  • Helps you maintain efficient inventory levels.
  • Comparison with Industry Standards:
  • Compare your inventory turnover with industry benchmarks.
  • Gauge your operational efficiency relative to industry peers.
  • Identify areas for improvement based on industry standards.

What Does High And Low Inventory Turnover Mean?

When your inventory turnover ratio is higher, you manage your inventory more efficiently. This is important because holding onto inventory comes with costs. You have to consider the expense of the products themselves, whether it's manufacturing or wholesale costs. Additionally, costs are associated with storing those products in warehouses and the labour involved in managing inventory and making sales. A more efficient system means healthier cash flow for your company.

On the other hand, if your inventory turnover ratio is low, your inventory isn't selling as quickly as expected. This could indicate poor sales performance, overstocking, obsolete inventory, or ineffective inventory management practices. Low turnover rates can tie up capital, increase holding costs, and potentially lead to financial losses. It's essential to address these issues promptly to optimise your inventory management and improve your company's financial health.

What Is A Good Inventory Turnover Ratio?

The ideal inventory turnover ratio varies depending on your business and industry. For instance, if you're in the electronics business, you might expect a higher turnover ratio compared to a furniture retailer.

Consider the example of a grocery store versus a bookstore. Grocery stores need a high turnover ratio because their products, such as fresh produce and dairy, have a limited shelf life. On the other hand, bookstores may have a lower turnover ratio since books typically have a longer shelf life and slower demand.

However, having a high inventory turnover ratio can also be problematic. For instance, if you're selling luxury items like watches or high-end electronics, an excessively high turnover ratio may indicate needing more stock and potentially missing out on sales opportunities.

Conversely, a low inventory turnover ratio means your inventory is stagnant. For instance, if you run a hardware store and certain items sit on the shelves for months without moving, it might be time to reassess your inventory management strategy.

How To Address A Low Inventory Turnover Ratio?

To tackle a low inventory turnover ratio, start by digging into your inventory. It’s important to ask the right questions.

Are some items just sitting there without selling? 

If so, figure out why. Maybe your competitors are offering lower prices, or market demand for those goods is dropping. If that's the case, it's time to adjust your pricing or update your product mix to stay competitive.

Next, take a look at your ordering process. Are you buying too much of certain items? 

If so, tweak your ordering strategy to match customer demand better. And if your sales team isn't pulling their weight, consider giving them some extra training to help them understand what customers want and make better purchasing decisions.

Keep an eye on your operations, too. Are there inefficiencies slowing things down? 

Streamline your processes to speed things up and prevent excess inventory from piling up.

Finally, always keep an ear to the ground and be ready to adapt. Markets change, and so should your business. Stay flexible and be willing to adjust your strategies as needed to keep your inventory moving and your business thriving.

How Can You Optimise The Inventory Turnover For Your Business? 

Here's how you can optimise your inventory turnover as a business owner:

  1. Tweak Your Prices: Take a good look at your pricing strategy. If something's flying off the shelves, you might want to bump the price a bit to make more money. And if you've got stuff that's just collecting dust, maybe it's time to cut the price or find other ways to get rid of it.
  2. Keep Your Suppliers in Check: Choosing suppliers with the cheapest prices might not always be the best move. Sometimes, getting your products quickly or reliably is more important, especially if they sell like hotcakes. So, streamline your supply chain to get rid of any hiccups, which will help boost your sales and profits.
  3. See How You Measure Up: Check out how your inventory turnover compares to others in your industry. If you're lagging behind, there might be ways to jump ahead by spotting trends and adjusting your inventory accordingly.
  4. Get Better at Predicting: Use your sales numbers and inventory reports to figure out what's going to sell and when. This can help you plan for the future and come up with new ways to sell stuff that's not moving as quickly.
  5. Optimise Inventory Layout: Organise your inventory in a way that makes it easy to find and access items. Order fulfilment can be sped up by speeding up the picking and packing processes.
  6. Make Ordering Easy: Automate your purchase orders to save time and reduce mistakes. With the right system, you can make sure you always have enough of the good stuff in stock without having to think about it too much.
  7. Invest in Inventory Management Software: With inventory management software, keep an eye on inventory levels, trends, and sales data. In addition to providing valuable insights, these tools can streamline the process of managing your inventory.

Now, it’s time to compare. 

Inventory Turnover Ratio Vs Inventory Turnover Rate

Regarding inventory management, you might come across two terms: "inventory turnover ratio" and "inventory turnover rate." Here's what they mean for you:

  • Inventory Turnover Ratio: This is a measure of how efficiently you're managing your inventory. It tells you how many times you've sold and replaced your inventory within a specific period, usually a year. You calculate it by dividing the cost of goods sold by the average inventory for the same period. It gives you a ratio indicating how well you manage your inventory and sales.
  • Inventory Turnover Rate: This term refers to the speed at which your inventory sells or is replaced. It's a more general measure and can be expressed in terms of the number of times your inventory is sold or replaced within a period, like monthly, quarterly, or annually.

So, while both terms are about how quickly your inventory is moving, the "inventory turnover ratio" gives you a specific ratio, while the "inventory turnover rate" is more about the speed or frequency of turnover.

Inventory Turnover Ratio Vs Inventory To Sales Ratio

My Table
Ratio Inventory Turnover Ratio Inventory to Sales Ratio
Aim Shows how fast you sell and replace inventory in a year. Compares how much inventory you have to how much you sell in a month or a year.
Calculated by Divide cost of goods sold by average inventory. Divide inventory value by sales revenue.
Interpretation High Inventory Turnover Ratio means you're selling quickly; low Inventory Turnover Ratio means slower sales. High ratio may mean you have too much inventory; low ratio may mean your inventory's too low for your sales.

So, How Can Aspire Help With Expense Management?

  1. Effortless Invoicing: With Aspire, creating, sending, and managing invoices easily. Our platform ensures seamless synchronisation and automatic reconciliation, helping you get paid faster and reducing administrative overhead.
  2. Real-Time Spend Control: Take control of your company's spending by setting budgets and tracking expenditure in real-time. With Aspire, you can establish spend limits, delegate tasks, and scale your business with ease, empowering you to manage finances effectively.
  3. Streamlined Payments: Automate bulk payments and payroll processing to streamline operations and reduce processing time. Aspire helps you save time and resources, allowing you to focus on growing your business without worrying about manual payment tasks.
  4. Simplified Payables: Our platform simplifies the payable process, enabling you to pay invoices with just an email forward. This optimises cash flow, centralises bill management, and ensures timely payments to vendors, improving efficiency and reducing errors.
  5. Custom Expense Policies: Create custom expense policies directly on Aspire to enforce compliance and control over employee spending. Our advanced rule engines allow you to build complex policies and accelerate operational workflows while gaining greater financial oversight.
  6. Integrated Expense Management: Aspire's integrated expense management solution offers instant corporate cards, streamlined claims processing, and robust spend controls. You can optimise processes, enhance financial efficiency, and ensure in-policy spending by automating expense management without compromising control.

So, boost your company’s expense management by opening a business account with Aspire today!

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About the author
Aaron Oh
is a seasoned content writer specialising in finance, insurance and tech industries. With a writing history at S&P Global, EdgeProp, Indeed, Prudential, and others, Aaron leverages finance knowledge and business insights to help businesses improve productivity and performance.
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