LGT's Profit Sense
If you run a manufacturing and distribution (M&D) company, inventory is most likely your largest asset, as well as being your revenue generator. Because inventory is the backbone of every M&D company, it is critical that you have systems and processes in place to manage your inventory effectively. Having too much or too little stock will put a drag on your bottom line and hurt your cash flow. How can you make sure you are effectively managing your inventory? There is actually one simple ratio that can help you evaluate the health of your inventory management—the inventory turnover ratio.
Understanding the Inventory Turnover Ratio
Determining your inventory turnover ratio will help you identify your business’ sweet spot in inventory management. The ratio is calculated in one of two ways:
- Inventory Turnover = Cost of Goods Sold / Average Inventory*
- Inventory Turnover = Sales / Inventory
*Average inventory can be calculated as (Beginning Inventory + Ending Inventory) / 2.
Both calculations are used frequently. However, the second is a less accurate representation of how long your inventory is truly on hand, since it includes the markup from cost.
What Does the Ratio Signify?
As a general rule of thumb, a higher ratio indicates more efficient inventory management (i.e., keeping less inventory in stock). This generally implies that you are paying lower storage fees and have fewer dollars tied up in your stock, which, in turn, could free up cash for investing or reducing borrowing needs. A higher inventory ratio also indicates that your risk of slow-moving or obsolete inventory is lower, which is especially important for technology, fashion, or other goods that are either fast-changing or lose consumer appeal quickly.
Understanding your inventory turnover will also enable you to maintain tighter control on your supply chain, helping you inch closer to a “just-in-time” inventory system. That said, be wary of turnover ratios that are too high; this indicates that very little inventory is on hand. If you receive a large, sudden order, you may have to incur additional costs to fulfill the order—or, you may not be able to fill it at all, especially considering today’s supply chain issues that many M&D companies are experiencing.
Amidst the COVID-19 pandemic, we saw several inventory turnover ratios increase for many of our M&D clients, which initially appeared to be favorable. However, upon further review, this increase in the inventory turnover ratio was actually due to unfavorable decreases in inventory as companies sold out of their stock (fast!) and were unable to replenish the inventory levels due to supply chain issues. As such, the rule of thumb that “the higher the inventory turnover ratio, the better” can generally be followed; however, additional analysis should be performed to ensure the increase in the turnover ratio is due to favorable circumstances.
Using the Inventory Turnover Ratio as a Comparability Tool
Using industry data to benchmark your inventory turnover ratio is a great way to understand what is normal for your business. However, your business is unique and, in turn, your most efficient ratio will also be unique, but industry trends can serve as a guideline. Calculate your inventory turnover ratio each month to create a trend analysis for budgeting and forecasting needs. The more history you have, the better you will be able to understand what is normal for your business and to identify changes in trends that signify changes in inventory management are necessary. The inventory turnover ratio can also be performed on a disaggregated level, such as on different product lines of inventory, to further assess any areas for improvement or to identify underperforming product lines.
How Can You Improve Your Inventory Turnover Ratio?
Now that you know just how valuable a tool the inventory turnover ratio can be, you might be wondering how you can improve yours. First thing’s first – calculate your current inventory turnover ratio. If you don’t have historical turnover ratios to compare to, let today be your starting point to improve the way your inventory is managed going forward. After you know your ratio, there are a multitude of ways to improve it. Here are some practical strategies. Ready to turn over a new leaf? Let LGT help. We’re ready to answer all your questions about inventory turnover ratios and other accounting issues.
- Order smaller quantities from suppliers more frequently
- Forecast your sales demands and order only what you expect to sell to meet expectations
- Reduce lead time from vendors and suppliers
- Use automated systems to track inventory and sales demands
- Research more affordable distributors
- Create a marketing campaign to increase sales
- Eliminate old or underperforming inventory and focus on top selling products
Have questions? We would love to help!
If you have any questions or would like additional information about anything mentioned, please comment below or email us at askus@lgt-cpa.com.
