If You Don’t Know Your Company’s Inventory Turnover Ratio, You’re in Trouble by Jason Kruger @FortuneMagazine August 29, 2016, 11:22 AM EST E-mail Tweet Facebook Linkedin Share icons Having spent 17 years in the business of accounting and financial analysis, it’s upsetting to see how few founders understand their company’s inventory turnover. And even fewer realize it’s a problem. If you’re in an inventory-based business, managing your inventory efficiently is critical to your profit and success. Too much and too little stock both drag down your bottom line. You may be wondering: What’s the solution, then? It varies based on the nature of your business, your industry, and your financials, but ultimately, it’s about finding a balance that’s right for your business. First, you need to determine your company’s inventory turnover ratio. This ratio helps you find the sweet spot between having so much product it becomes obsolete and having enough so it doesn’t hinder sales. It will help your inventory flow smoothly through your supply chain, keeping your customers happy and increasing your margins. Here are some things to keep in mind as you calculate your inventory turnover ratio. What is inventory turnover? Inventory turnover is a simple ratio showing how many times a company’s inventory is sold and then replaced over a period of time. It measures the amount of capital invested in inventory. The higher the inventory turnover number, the more often inventory is “turned,” or replaced, which means the company is more efficient at managing its inventory. Often, the ratio is calculated as: Inventory turnover = Net sales / Inventory Sometimes it is calculated as: Inventory turnover = Cost of goods sold / Average inventory, where average inventory is ideally the average ending inventory for the previous 12 months. Generally, it’s better to err on the side of less inventory rather than more. Less inventory on the shelves means less risk of damages and obsolescence, as well as greater protection against fluctuating market prices. Yet there is also risk in having too high an inventory turnover rate. Not having enough stock on hand to meet a sudden surge in demand can cause a stock-out, leading to missed sales and unhappy customers. On the other hand, companies turning their inventory over at a sluggish pace, or overstocking, are unnecessarily limiting their cash flow, and may get themselves into a position of needing to sell their stock at cost or liquidate at a loss. These are not situations you want for your business. Instead, your business needs to find the right balance between having too much inventory and not enough. Finding your ideal turnover ratio Inventory turnover ratio varies by industry. While you can get an idea of what your industry-specific turnover ratio should be by consulting this resource, nothing replaces crunching the numbers yourself. The best method to find your ideal inventory turnover is to use your inventory software, such as QuickBooks, NetSuite, Sage 100, and Dynamics GP, to evaluate what products are selling more than others. To optimize inventory turnover, companies must ensure that the products in demand are shipped and delivered to the customer in the shortest timeframe. Different supply chain management techniques will also influence inventory turnover ratios. For instance, reducing purchase order quantity and increasing the frequency means less inventory sitting idle in your facilities. Another way to reduce inventory hold times is by improving efficiency for inbound transportation. For the best supply chain strategy, it’s important to compare your numbers against companies with a similar structure to determine the most relevant benchmarks. For example, comparing two companies, one that carries inventory and another that drop ships directly from the manufacturer, shows how completely different inventory turnover ratios do not tell the entire story. To get a handle on your inventory turnover rate, it’s important to keep up with your financials to evaluate performance and metrics. It also requires using effective inventory management software to track and monitor your inventory on a regular basis. Inventory turnover for high-growth companies In the appealing chaos of a rapidly growing business, regular financial reporting can sometimes go by the wayside, which is a big mistake. Financials are key. Keeping up with financials allows these companies to evaluate performance and metrics, at least once per month. By keeping up with day-to-day accounting, companies can turn their receivables faster than their payables. They need to sell inventory, collect revenue, and then pay their vendors to avoid cash-flow shortages. Using digital tools to analyze product lines, sales efficiencies, and order lead times, help ensure delivery schedules can meet customer demand on time. This is especially important for rapidly-growing companies. They must have real-time inventory on hand, and make sure their inventory back-order system is in place to avoid ordering traditional inventory that is already tucked in the back corner of one of their warehouses. Improving your turnover ratio There are many ways to improve your turnover ratio, whether you need to get old stock off the shelves or receive inventory more often. Here are a few ways to make your inventory turnover more efficient: Reduce the price of obsolete or excess inventory to get it out the door and free up cash Work with suppliers to deliver purchases more frequently Create ways to forecast sales demands Implement cycle counting of inventory balances, either on a daily, weekly, or monthly basis Limit bulk orders to big sellers to prevent excess inventory on the shelf Companies can also evaluate how inventory shipments are managed. For example, some companies will only ship to a customer when all the back-orders have been complete. Others will ship as product is received in the warehouse, such that multiple shipments are sent to the customer. Either method is acceptable but in a high-volume industry, this can impact inventory turnover ratios. Whether the issue is too much inventory or not enough, businesses are wise to determine their inventory turnover ratio and use that to make more informed purchasing decisions for the future. The result is better business and a more desirable bottom line. – Jason Kruger is the president of Signature Analytics.