Inventory turnover ratio is a major indicator of the health of a business. Businesses operating with inventories analyze this ratio as an indicator of the viability of the business. It is regretted to note that many business owners are not aware of this fact and make baseless inventory decisions, which in the long run leads to aging of unsold stock; resulting in loss or stagnation.
What is Inventory turnover?
Inventory turnover ratio indicates the sale of goods over a given period of time. This is defined as the ratio of the cost of sales to the average stock held. But what does inventory turnover mean to your business? High turnover may be a good indicator that your business is healthy. This may not always be the case, as you could be under-stocked and losing more sales unaware of it. Low inventory turnover, on the other hand, shows you are taking too long to sell inventory or your stock is aging on shelves unsold. Stock aging is a major setback for any business as it leads to low turn over, thereby resulting in losses to the business. It is for this reason that it is very critical for every business owner to use the Inventory turnover system to correct decisions and make a success of their business.
For example, a company with $10 million annual cost of sales and having $3 million opening and $5 million closing stock, would have an Inventory turnover of 2.5.
By definition, Inventory turnover = Cost of sales/Average stock held
Therefore Inventory turnover =$10,000,000/(($3,000,000+$5,000,000)/2) = 2.5
This indicates that the stocks were replenished 2.5 times annually or in other words the inventory was depleted and restocked 2.5 times a year. This is a low turnover, which could result in the business stock aging and it is time for the business owner to make the right decisions to improve the turnover. Is the calculation too complicated? Do not fret or worry, as a good accounting or inventory software will do this for you automatically. However, it is very important to identify the type of stock that is the cause for the low inventory turnover, as this is affecting your business.
How do you identify these stocks and how do they affect your business?
- Redundant/Obsolete Stock
When a product takes too long to be sold or completes its product life, it is referred to as obsolete stock. With no expectation to be sold in future, the product is devalued and sold, thereby resulting in a loss. Continuing to store it on your shelves adds to holding and insurance costs. In fact, according to accounting principles obsolete stock should be written off as expenses, as they only reduce the business profits. Therefore, by using Inventory turnover you will get an indication that your current system of stocking is incorrect. This should lead you to make correct decisions regarding future stocks.
- Expiring stock
We are all consumers of certain perishable products, for example, food, beverages or even medicines; this means that the demand for the product is very high. But the perishable nature of these products may cause great loss to the seller. If you stock perishable inventories such as food, beverages and medicine and they reach the expiry date, you throw them away or sell them for other uses at a reduced price. As you purchased the inventory, it amounts to a loss of your money and envisaged profits too. Therefore, the Inventory turnover ratio is extremely important to determine the turnover of this product and to avoid losses by ordering stock correctly.
- Out of season stock
When Summer is over so are sales associated with it, and you are forced to keep the remaining inventories until next summer. Every season comes with hopes of very high sales for certain products; for example, warm jackets for winter and fancy clothes for summer. With this hope of good sales and not using a proper evaluating system, many business owners may overstock unknowingly. And even though many people may think there is no harm in this, it causes businesses more harm than good. Imagine the uncertainty of holding clothes until the next season. Will they still be fashionable with the ever-changing fashions? One is left in a quandary, as you have to incur holding costs and you are not even sure whether they will be sold next summer at a profit.
- Slow moving stock
Every business owner buys inventory expecting that the demand is high and he/she will make sales fast and reinvest more. But mere expectations without facts may lead to purchasing slow-moving stock, which has happened to many businesses. These inventories hold up the business capital, as for example, one may lack funds to purchase fast moving goods since the slow-moving stock are preventing the expected cash return from sales. They also incur holding costs, thereby resulting in businesses incurring more cost by way of marketing and offering discounts. And in adverse cases, these stocks stay long on shelves and become obsolete inventories.
In the aforementioned discourse, you would have understood how proper inventories could affect your business? Inventory turnover is an important system for every business to determine the sale of the product they are holding and guide them to the best return. It will also help in making decisions with regard to aging stock and avoiding holding stock.
Therefore, to run any business successfully, it is important to analyze the inventory turnover!
As mentioned earlier, with the best inventory software, it is easy to analyze the Inventory turnover ratio and be able to make the correct decisions at the right time. Contact us to help you choose the right App for your business!