Without the right tools and knowledge, companies in the consumer packaged goods industry can easily end up with an inventory imbalance. Too little stock means missed sales opportunities, lost economies of scale, and dissatisfied customers. The opposite doesn’t look good, either. Too much triggers cash flow issues, increased holding costs, and stock depreciation. That’s why mastering inventory turnover ratios is critical. Let’s explore how this crucial metric can enhance your inventory management practices and drive your business forward.
What are inventory turnover ratios, and how are they calculated?
The inventory turnover ratio shows how frequently a company sells and restocks its inventory over a given period, usually a year. Knowing this metric helps you understand your company’s sales and inventory management practices.
To calculate your inventory turnover ratio, divide your cost of goods sold (COGS) by your average inventory for the same period.
- Cost of Goods Sold (COGS) – These are the direct costs of making your product, such as raw materials, packaging, labor, and freight charges. Indirect expenses, like sales, marketing, and administrative costs or interest payments, are not included.
- Average Inventory – This is your typical inventory value over a specific period. The average inventory considers fluctuations, giving you a steadier baseline to work from.
Average Inventory= (Beginning Inventory+Ending Inventory)/2
To demonstrate, let’s look at the variables of a supermarket.
Cost of Goods Sold (COGS) for the year: $2,400,000
Beginning Inventory at the start of the year: $300,000
Ending Inventory at the end of the year: $200,000
Inventory Turnover Ratio = COGS/Average Inventory
Inventory Turnover Ratio = $2,400,000 / (($300,000 + $200,000)/2)
= $2,400,000 / $250,000 = 9.6
This means that the supermarket sold and restocked its inventory approximately 9.6 times over the year.
Limitations of Using Inventory Turnover Ratios for Analysis
While inventory turnover ratios are valuable, they do have a few constraints.
- They don’t fully represent your sales efficiency or profitability because they don’t consider your actual sales volume or profit.
- You can have different inventory turnover ratios depending on the accounting method you use (i.e., using FIFO, LIFO, or average cost to calculate the COGS).
- They overlook external factors, such as market demand, economic conditions, or seasonality, which can greatly impact inventory levels and turnover rates.
- They don’t distinguish between high-value or slow-moving items and those that are lower in value but turn over more quickly. This can mask problems in specific segments of your inventory.
- They provide a snapshot of your business efficiency, not the dynamic story. Let’s say your business is growing or contracting significantly. In either case, your beginning and ending inventories won’t be representative of the entire period.
Despite these restrictions, inventory turnover ratios can give you a crucial health check on your operations, helping you make strategic buying, pricing, and selling decisions. When combined with other data, this metric becomes a vital tool that keeps your cash flow strong and your business profitable.
Interpreting Inventory Turnover Ratios
So, is a high inventory turnover ratio good? What does a low inventory turnover ratio mean?
A high inventory turnover ratio is usually positive because it indicates that your products are selling quickly. This is particularly important if your items have limited shelf lives or are trend-sensitive. With a fast turnover, you don’t have to worry if your perishable goods will expire or if you need to increase your budget for storage and insurance costs. It also reflects a strong market demand and effective supply chain management. Yet, it can also mean you’re understocked, which can be a problem.
Conversely, a low inventory turnover ratio could signify overstocking, poor product selection, or ineffective marketing. These issues are critical because unsold items can quickly become unsellable due to expiration or inventory obsolescence, leading to considerable losses. But a low turnover ratio may not necessarily be a bad thing. It could be a deliberate result of stockpiling for high-demand periods or buffering against supply chain uncertainties.
In either case, you must understand the context to interpret your inventory turnover ratio accurately. The ideal turnover ratio typically depends on your specific product category or industry. Products with shorter shelf lives, such as food and beverages, require higher turnover rates to avoid spoilage and waste. Alternatively, non-perishable goods might tolerate slightly lower turnover rates but still demand efficiency to stay relevant to consumer trends and preferences.
Strategies to Optimize Inventory Turnover
Maintain a healthy balance between sales and inventory levels with these tips:
1. Restock the smart way
Order in smaller quantities more frequently to avoid overstocking and keep your inventory fresh. This ensures optimal stock levels to consistently satisfy customer demand without locking up too much capital in unsold goods.
2. Become a preferred customer
When you have a good business relationship with your suppliers, they prioritize you. They’ll want to help you protect your inventory levels, especially when there are stockouts in your industry. Preferred customers are also likely to experience timely deliveries, shorter lead times, and even better terms.
3. Apply a dynamic pricing strategy
Adjust prices according to market demand, competition, and seasonal trends to stimulate sales for slow-moving items or clear out old stock. This not only boosts sales but also helps maintain a healthy inventory turnover rate.
4. Leverage technology
Inventory management systems can deliver real-time insights into sales trends, stock levels, and reordering processes. With advanced forecasting methods and automation, you can reduce overstocking and always have your products available.
5. Get the right financing
Keeping your inventory at the perfect level is tough. No matter how hard you try, predicting every twist and turn in business is a big ask. Overstocking or waiting on unpaid invoices can really pinch your cash flow, blocking you from scaling or growing your business. You need innovative financing that will not restrict you with limited funds, steep interest rates, or inflexible paying options. Enter Kickfurther.
Why Kickfurther?
With Kickfurther, eliminate stockouts, keep up with demand, and move into growth mode. Here’s what we offer:
- No immediate repayments: You don’t pay back until your new inventory order begins selling. You set your repayment schedule based on what works best for your cash flow.
- Non-dilutive: Kickfurther doesn’t take equity in exchange for funding.
- Not a debt: Debt financing options can sometimes further constrain your working capital and access to capital—even lower your business’ valuation if you are looking at venture capital or a sale. Kickfurther is not a loan, so it does not put debt on your books.
- Quick access: Get the capital you need when your supplier payments are due. Kickfurther can fund your entire order(s) each time you need more inventory.
Kickfurther puts you in control of your business while delivering the costliest asset for most brands. By funding your largest expense (inventory), you can free up existing capital to grow your business wherever you need it—product development, advertising, and expanding your team.
Interested to know how you can secure inventory funding from Kickfurther? Just follow these easy steps:
- Create your free business account.
- Complete the online application.
- Review a potential deal with one of our account reps to get funded in minutes.
See how much funding your brand can access, and discover how Kickfurther can accelerate your momentum today!
