Inventory Turnover Ratio: The Ultimate Metric for E-commerce Growth
July 13, 2023
As previously mentioned, overhead costs are reduced and, as a result, the company’s profitability performance improves by minimizing inventory holdings. Ideally, the inventory turnover ratio would be found by dividing sold units by on-hand units. However, because the financial statements themselves only contain monetary valuations, external evaluation of inventory turnover must rely on the valuation metrics recorded under GAAP:
Cost of Goods Sold/Average Inventory = Cost of Goods Sold/(Beginning Inventory+ Ending Inventory)/2
While it is theoretically better to benchmark the Cost of Goods Sold for the entire year by using the average balance sheet inventory amounts, some analysts simply use the ending inventory number for computational expediency, which causes a minor inaccuracy in firing.
Inventory Turnover Ratio
When product flow changes over the year and inventories contract and grow over time, more frequent inventory level measurements are needed to determine an accurate average inventory level.
Exhibiting high and low turnover ratios simplifies inventory turnover ratio explanations. Inventory issues prevent many businesses from surviving this. A low inventory turnover ratio indicates that a company may have overstocking or a lack of marketing or product line effort. Because inventory typically has high storage costs and zero return rates, it is a sign of ineffective inventory management. An increased inventory turnover ratio is seen as a good sign of good inventory management. Nevertheless, a higher inventory turnover ratio does not necessarily imply better performance.
The inventory period, which is the number of days worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold, is a common term for inventory turnover:
Inventory Period = Average Inventory/Annual Cost of Goods Sold
There are several things to keep in mind when calculating the turnover ratio: –
Only think about the cost of goods sold from stock sales filled with warehouse inventory. Direct shipments and non-stock items are not included. It is clear that these sales are significant, but they don’t include your inventory investment.
The formula’s cost of goods sold figure includes the number of stock goods that are transferred to other branches and the amount of these goods that are used for internal purposes like repairs and assemblies.
Inventory turnover ratio is based on the cost of items (what you paid for them), not sales dollars (what you sold them for).
The average value of stocked inventory determines inventory turnover. Calculate the total value of every product in inventory (quantity on-hand times cost) on the same day every month to find your average inventory. Be sure to use the same cost basis (average cost, last cost, replacement cost, etc.) when calculating the cost of goods sold and the average inventory investment.
If your inventory levels tend to fluctuate throughout the month, calculate your total inventory value on the first and fifteenth of each month. Find the average inventory value by averaging all inventory valuations from the previous twelve months.
Flaws in Inventory Turnover Ratio Calculation and Implications for Financial Analysis
The average value of stocked inventory determines inventory turnover. Calculate the total value of every product in inventory (quantity on-hand times cost) on the same day every month to find your average inventory. Be sure to use the same cost basis (average cost, last cost, replacement cost, etc.) when calculating the cost of goods sold and the average inventory investment.
These are:
1. Utilizing Sales Revenue rather than Cost of Goods Sold in the numerator.
2. Failing to account for the off-balance sheet LIFO Reserve in the denominator.
If your inventory levels tend to fluctuate throughout the month, calculate your total inventory value on the first and fifteenth of each month. Find the average inventory value by averaging all inventory valuations from the previous twelve months.
Turnover Goals
Consider the average gross margin you receive on product sales when you determine your inventory turnover goals. Distributors with 20% to 30% gross margins should aim for five to six turns per year. When your business has high gross margins, you can afford to rotate your inventory less often.
A six-turn turnover rate per year doesn’t mean that every item’s stock will turn six times. The stock of popular, fast-moving goods should be rotated more frequently—even twelve times a year. Items that move slowly may turn only once or even not at all.
Finally, calculate inventory turnover for each product line in every warehouse individually. This will help you find out when your inventory is not earning enough return on investment. Reducing the quantity you typically buy from the supplier can help improve inventory turnover. When you buy less of a product and more frequently, inventory turns out to improve.
Companies have few funds to invest in inventory. They can’t have a lifetime supply of all things. Firms must sell the goods they bought in order to get the money necessary to pay bills and return a profit. The rate of inventory turnover is a measure of how quickly inventory is moving through the warehouse. Inventory turnover, when used in conjunction with other metrics such as return on investment and customer service level, can provide a reliable indicator of a company’s success.
Interpretation of stock turnover ratio
The inventory turnover ratio creates a connection between the following components:
- Cost of goods sold
- Average inventory
The result of the stock turnover ratio formula shows how many times a company has managed to sell all of its stocks within a year. Increased inventory turnover is not always a sign of better performance. Insufficient inventory can also lead to sales opportunities being lost. Cost of goods sold, also known as revenue cost, refers to the direct costs involved in producing goods or services, which include material, labour, and overhead costs that are sold. These expenditures are directly connected to income. The actual cost of the produced and sold goods is what the term “cost of goods sold” is meant to indicate.
Conclusion
A common measurement of how well a company manages its assets is the inventory turnover ratio. As previously mentioned, overhead costs are reduced and, as a result, the company’s profitability performance improves by minimizing inventory holdings. Exhibiting high and low turnover ratios simplifies inventory turnover ratio explanations. Inventory issues prevent many businesses from surviving this.
A low inventory turnover ratio indicates that a company may have overstocking or a lack of marketing or product line effort. The formula’s cost of goods sold figure includes the number of stock goods that are transferred to other branches and the amount of these goods that are used for internal purposes like repairs and assemblies. If your inventory levels tend to fluctuate throughout the month, calculate your total inventory value on the first and fifteenth of each month.
Find the average inventory value by averaging all inventory valuations from the previous twelve months. Companies have few funds to invest in inventory. They can’t have a lifetime supply of all things. Firms must sell the goods they bought in order to get the money necessary to pay bills and return a profit. Cost of goods sold, also known as revenue cost, refers to the direct costs involved in producing goods or services, which include material, labour, and overhead costs that are sold. These expenditures are directly connected to income.
