The importance of inventory turnover

Speed matters in business. Speed matters A LOT in business…

Often, speed in business references time to customer acquisition, how quickly a project can be completed, how fast collections on invoices happens, or customer response times. All of these “speed measures” are critical to providing the customer with an enhanced experience or to the financial success of a business. However, specific to manufacturing or retail companies, the most critical “speed metric” is often overlooked – Inventory Turnover.

Companies that manufacture and sell a B2B or a B2C product often have a value of inventory that exceeds cash balances of the business. Revenues are a function of Price * Quantity and one of the main objectives in business is to drive growth and “top line” revenues. A key performance metric for measuring how a company is efficiently managing the Quantity side of their revenue equation and assets on a Balance Sheet is an Inventory Turnover Ratio. Inventory Turnover Ratio is the ratio of Cost of Goods Sold / Average Inventory during the same time period.

In short, the Inventory Turnover Ratio provides insight on how long cash is tied up in the cycle of being used to purchase raw materials or a finished product for sale through to selling the product. Specific Inventory Turnover Ratios vary from industry to industry. The higher the Inventory Turnover Ratio, the more likely it is that a business is carrying too much inventory. Overstocking means that cash is being tied up in inventory assets for a prolonged period. As a result, the correlation between elevated Inventory Turnover Ratios and the business operating in a “cash strapped” mode is exceedingly high.

It is critical that Executive Management teams, inventory/warehouse managers, buyers, and marketing teams review and analyze Inventory Turnover Ratios. One of the best methods for reviewing Inventory Turnover Ratios is to track the ratio at a product type or “sku” level and graph the ratio in monthly increments over a trailing 13 month period. Using a trailing 13 month snapshot will assist the business in better understanding seasonality and internal buying cycles. The goal is to move inventory with ever-increasing speed and create a downward trend in the Inventory Turnover Ratio.

Depending on circumstances or the individual market, a business can improve reporting when other performance metrics are graphed on a secondary y-axis along with the Inventory Turnover Ratio over a trailing 13 month period. For example, graphing a product’s gross product margin can give insight into the relationship between the speed at which a product is processed through inventory at various price points. Graphing monthly revenues generated by a specific product against the Inventory Turnover Ratio will provide additional insight in potential seasonality of a product and improve buying patterns.

Inventory can be a very complicated topic. Handled properly, excellent financial reporting can be the key to improving the Inventory Turnover Ratio in your business. Contact TGG Accounting today. We can help implement best practice strategies to help you manage your inventory cycles.

Written by:
Andrew Ruff
TGG Accounting

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