Inventory turnover – an introduction
Inventory is a significant asset for an e-commerce business, whether it’s a retailer, wholesaler, or manufacturer. Inventory turnover is a critical metric for e-commerce businesses to assess how well they’re managing their inventory. It’s a ratio that shows how many times they have sold and replaced inventory within a specific period.
What is inventory turnover?
Inventory turnover is a financial metric that shows how efficiently a company is selling and replenishing its inventory. It’s a ratio that measures how many times a company has sold and replaced its inventory over a specific period, normally a year or a quarter. It’s an important ratio to monitor because it reflects how much of a company's inventory is being sold and how quickly it’s being replenished. Or in other words, how much working capital is tied up in inventory.
Many businesses will also refer to inventory as stock, we will use the term inventory throughout this metric.
Why is inventory turnover so important?
Inventory turnover is a critical metric for businesses because it helps them understand how well they’re managing their inventory. A low inventory turnover ratio means that a company is holding too much inventory, which ties up capital and incurs carrying costs, such as warehouse storage and insurance.
On the other hand, a high inventory turnover ratio indicates that a company is efficiently managing its inventory, selling products quickly, and replenishing its inventory to meet customer demand.
What is a good inventory turnover?
In the retail industry, an inventory turnover ratio of six or higher would be seen as good. The ideal inventory turnover ratio naturally varies, but a higher ratio is better. A high inventory turnover ratio indicates that a company is selling products quickly and efficiently managing its inventory.
However, it's important to note that a high inventory turnover ratio could also indicate a company is running low on inventory, which could lead to stockouts and lost sales.
A low ratio of two or lower could indicate that a company is holding on to inventory for too long, which could lead to excess inventory, spoilage, or obsolescence.
What does inventory turnover look like?
How do you calculate inventory turnover?
The formula for to calculate inventory turnover is:
Inventory turnover = Cost of goods sold / Average inventory
To calculate the inventory turnover ratio, you need to know your cost of goods sold (COGS) and average inventory for the period you're measuring.
COGS is the cost of the inventory that was sold during the period. This will be available in your management accounts. To calculate COGS, you subtract opening inventory from closing inventory, and add the cost of purchases during the period (and subtracting any returns or allowances).
Average inventory is the average amount of inventory held during the period. A simple calculation for this would be by adding the opening inventory and closing inventory and dividing by two. A more accurate way to calculate average inventory is to use closing inventory for each month in the period and dividing by the number of periods.
Inventory turnover worked example
If a business has the following cost of goods sold and inventory, its inventory turnover is calculated like this:
Cost of goods sold
- For the year: £4,700,000
- For the quarter: £1,700,000
Inventory
- End of year: £2,400,000
- Start of year: £1,100,000
- Start of quarter: £2,200,000
Inventory turnover (annual) = £4,700,000 / ( (£2,400,000 + £1,100,000) / 2 ) = 2.7
Inventory turnover (quarter) = £1,700,000 / ( (£2,400,000 + £2,200,000) / 2 ) = 0.7
Note: As you may expect, inventory turnover for the quarter is almost one quarter of the annual inventory turnover, although this isn’t always the case.
Conclusion
Inventory turnover is a crucial metric for an e-commerce business that manages inventory. It helps the business understand how well they’re managing their inventory and whether they need to adjust their inventory management practices. A high inventory turnover ratio indicates that a company is efficiently managing its inventory, selling products quickly, and replenishing its inventory to meet customer demand. Alternatively, a low inventory turnover ratio means that a company is holding onto inventory for too long, which could lead to excess inventory, spoilage, or obsolescence. By calculating and monitoring inventory turnover, companies can make informed decisions about their inventory management practices and improve their bottom line.
