The Inventory Turnover Formula and Calculation is as follows:
Inventory Turnover = Sales / Average Inventory
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
Let’s look at an example:
Company A is concerned about a sales slump in the first quarter of 2020 (January through March). Although March was a major outlier, he reports quarterly data to the Board. Because the President of Company A has a timely and through accounting team (maybe outsourced), he ascertains the following data:
- January – March 2019 sales = $250,000
- January 2019 beginning inventory = $50,000
- March 2019 ending inventory = $50,000
- January – March 2020 sales = $150,000
- January 2020 beginning inventory = $50,000
- March 2020 Ending inventory = $100,000
Q1 2019 Inventory Turnover = $250,000/(($50,000+$50,000)/2) = 5
Q1 2020 Inventory Turnover = $150,000/(($50,000+$100,000)/2) = 2
In this case, Q1 of 2020 sees a significantly lower Inventory Turnover Ratio revealing less efficiency and too much inventory (given that sales are decreasing).
It’s valuable to know how fast a company sells inventory. Equally valuable is knowing how you’re stacking up against yourself over different periods and how you to competitors (benchmarking).
Generally, as sales increase, so should the inventory ratio. More demand means that you’ll need more supply. However, in some scenarios, a higher ratio could also mean too much inventory on hand.
Care to get really sophisticated? You can perform an inventory ratio on isolated items, revenue streams or any specific ‘widget’ (if you sell more multiple items).
Care to take it farther? Project your Inventory ratio. Sales may be a bit unpredictable but take a shot. If you have a reasonable estimate for sales, and you know your target ratio, perhaps based on historical success in this area, you can back into the amount of inventory you should have on hand. You’ll have to reach back into hallowed antiquity and use what you learned in algebra.
WHERE IT GETS TRICKY: All recessions end. When demand suddenly increases, how will you be ready for it? Remember, inventory is cash so if you have too much too early, you could be dead in the water. It helps to have a pro work with you to use economic and seasonal data and history to help anticipate your needs and bolster cash flow while not leaving anything on the table for a competitor to gobble up.