For many small businesses, effective inventory management can be the difference between a positive and negative cash flow. Simply understanding your inventory turnover, can be the start of building efficiencies that will have a beneficial impact on your small business finances.
Inventory turnover ratio is the measure of how often you sell and replace your inventory and is the basis on which all inventory management can be built. Each industry – and indeed, products within categories – will have a different turnover ratio, but, for most industries, the ideal ratio will be between 5 and 10 – meaning the company will sell and restock inventory roughly every one to two months.
How to calculate inventory turnover ratio
Calculating an inventory turnover ratio involves a fairly simple calculation. Owners should divide the cost of goods sold (COGS) over a defined period (normally a fiscal year), by the average inventory price for that period.
Let’s use a simple retail model as an example. Over the course of the year, the shop sold £300,000 of goods, with direct costs associated to those goods of £150,000. This gives a COGS value of £150,000. At the opening of the fiscal year, it had an inventory value of £10,000 and a closing inventory value of £20,000.
Value of goods sold: £300,000
COGS: £150,000
Average inventory value: £15,000
Inventory turnover ratio = 10 (£150,000/ £15,000)
We then divide the days in the period by the turnover ratio, which enables us to understand that it takes on average 36.5 days to sell your inventory (365/10).
Having this information can help understand the optimum level of stock and reduce the impact of poor inventory management on your cash flow.
