Inventory turnover ratio, a measure of financial ratio analysis helps to understand how effectively inventory management is carried out by the company. Generally, companies prefer a higher inventory turnover ratio as compared to industry standards. The article highlights interpretation of the ratio apart from discussing the need and ways to improve this ratio.
Definition of Inventory Turnover Ratio
Inventory turnover ratio determines the number of times the inventory is purchased and sold during the entire fiscal year. This ratio is important to both the company and the investors as it clearly reflects the company’s effectiveness in converting the inventory purchases to final sales.
There are two variations to the formula to calculate inventory turnover ratio. The most commonly used formula is dividing the sales by inventory. The other formula divides the Cost of Goods Sold (COGS) by average inventory. The latter takes into the account the fluctuations in inventory levels throughout the year. The second variation is better as both COGS and inventory are recorded at cost whereas sale in the first formula is recorded at market value.
Why Is It Necessary to Improve Inventory Turnover Ratio?
Generally, companies prefer higher inventory turnover ratios. The need for improving the ratio arises when a stock turnover ratio is lower than industry standards. A lower ratio indicates that the company does more stocking than is required. Generally, if the product sale is faster, inventory operation is more efficient. This is because the inventory churning would be faster and thereby inventory turnover ratio would be better. This means the business needs less blockage of funds/investment in inventory for on-going operations of business. So, it is best to have a proper plan for improving inventory turnover ratio either by concentrating on better sales or by lowering the blockage of funds on a stock.
How to Interpret Inventory Turnover Ratio?
The inventory turnover ratio is very easy to calculate but little tricky to interpret. Firstly, the ratio for any company should be analyzed by keeping the industry standards in mind. Secondly, different cost flow assumptions like FIFO and LIFO result in different inventory turnover ratios in varying scenarios. Even inventory methods like just-in-time influence the ratio in different ways. Generally, a low inventory turnover ratio will signal bad sales or surplus inventory, which can be interpreted as poor liquidity, overstocking and even, obsolescence. A high inventory turnover ratio, on the other hand, will indicate good sales or buy in small amounts. It also implies better liquidity, but can also signal inadequate inventory at times.
How to Improve Inventory Turnover Ratio?
Once you have analyzed the inventory turnover ratio, keeping in mind all the necessary facts, and have come to a conclusion that the ratio is low; it is time to work on improving the turnover ratio.
There are several ways in which the inventory turnover ratio can be improved:
The company needs to pay more attention to the forecasting techniques. If you can forecast the demands of the customer correctly, you need to stock only those items. This will reduce your inventory levels, which in turn will increase the inventory turnover ratio.
Another way to improve your inventory turnover ratio is to increase sales. The company needs to formulate better marketing strategies to create more demand in the industry and thus, give a push to its sales. These could focus on advertisements or have promotional events and offers.
Reduce the Price
If you cannot increase the demand/sales by marketing, apply the discount strategy or reduce the price to an attractive level so as to increase the sales. For items having the lower sale, you can cut short on margin with a permanent low price to clear the inventory faster.
Better Inventory Price
Contact your vendors to reduce the price they quote you for the inventory items. This way you can reduce the inventory cost.
Focus on Top Selling Products
Apply the Pareto’s ‘80:20’ principle and invest only in the products that get you the maximum profit. Eliminate products that are creating losses for you and reducing the bottom line. Effectively, eliminating the specific inventories having lower turnover ratio will improve the overall inventory turnover for the company as a whole.
Better Order Management
Focus more on obtaining advance orders. This will help to eliminate unnecessary inventory and improve your inventory turnover ratio.
Eliminate Safety Stock and Old Inventory
Generally, companies keep excess product to meet unseen demands. This leads to excess inventory. If you are focussing on better forecasting techniques, there is no need for investing in safety stock. Further, cut your losses and dispose of the old inventory. Invest the same money in faster-moving products.
Reduce Purchase Quantity
It is best to devise a strategy of optimum purchase. Instead of ordering higher quantity, it is better to buy lower quantity and replenish the stock once the product’s major quantity is sold. Purchase needs to be in line with demand.
Conclusion: It is evident that the companies cannot afford to ignore the inventory turnover ratio. While analyzing this ratio, it is imperative that you keep a lot of factors in mind. A lower inventory turnover ratio certainly needs to be improved. However, an excessively high turnover ratio is also not a healthy sign for the company.