An inventory turnover ratio is a key performance indicator that shows how much sales a business is making. For retail businesses, this number is vital, as it provides necessary data that can help make good business decisions that can boost sales.
This article will introduce the inventory turnover ratio and how it relates to the average small retail business. It will show how you can calculate the turnover ratio and its general importance. It will then walk you through what is considered a healthy inventory turnover ratio. This will help you make an informed decision on what this number might mean for your own business, and how to improve it. By the end of this article, you should have a solid baseline understanding of the inventory turnover ratio. So let’s get started.
What is Inventory Turnover Ratio?
Inventory turnover is a term that shows business owners the number of times they sell their products over time. Normally you calculate the inventory turnover ratio in terms of years. However, many businesses also calculate it monthly or quarterly. In retail businesses, this ratio is an important parameter that gives you the lowdown on the speed at which you sell your overall products. Therefore, armed with this number, you have a clear picture of your general financial position.
How do you calculate your inventory turnover ratio?
For any business, there is a simple formula you can use to get your inventory turnover ratio. Below is the formula:
Inventory Turnover Ratio = Amount in Sales of Products Generated/Average Inventory
To further understand how to use this formula and the effect inventory turnover ratio has, below are two examples to help you understand how this number might work in the real world.
Example 1
A retail shoe business sold £100,000 worth of sneakers in 2020, and they held an average of £50,000 in inventory. What is the inventory turnover ratio?
Inventory Turnover Ratio = £100,000/£50,000
So, their inventory turnover ratio is 2.
What to Note: From the answer obtained, it means that the retail business had to restock their entire inventory twice a year. From this, we can conclude that they are selling at a profitable rate.
Still confused? Let’s try another one.
Example 2
A hair retail business sold £200,000 worth of hair in 2019. On average they held £500,000 in inventory. What is the inventory turnover ratio?
Inventory Turnover Ratio = £200,000/£500,000
Their inventory turnover ratio is 0.4
What to Note: From the answer obtained, you might say that the retail business is holding and spending on too much inventory. They have money tied up in stock, and they are undoubtedly spending more to store them than they are making in revenue from selling.
What is a Good Inventory Turnover Ratio for Retail Businesses?
You already have an idea of the inventory turnover ratio. However, what is the direct application of this formula to your retail business? What inventory turnover should you aim for as a retail business owner. As a retail business owner, an inventory turnover ratio your business should aim for is between 2 to 4.
Why not a lower inventory turnover ratio?
A lower inventory turnover ratio than 2 shows might signal a decline in sales. This can be due to a decrease in the popularity of products, a weak marketing force, etc. It also means that you are also spending a large proportion of your budget on keeping/storing your stocks. This is something that will affect your retail business.
As a retail business, you undoubtedly want to make tremendous sales and not only remain relevant. Therefore, you should scrap having an inventory turnover ratio below 2.
Why not a higher inventory turnover ratio?
What about an inventory turnover ratio above 4? What does a high number say about your retail business?
Contrary to what you might think, an extremely high value is not a good thing for retail businesses. For example, if you have a value of 7, it can indicate a low stock level. Consequently, you might be missing out on sales because you are out of certain stock or aren’t holding enough supply to keep up with demand. Also, in terms of logistics, this might mean you are worrying more about getting your products than selling them.
Having an inventory turnover ratio of 2 to 4 will help your business perform well and help you achieve your goals without getting overwhelmed along the way.
Why It’s Important to Measure the Inventory Turnover Ratio
Not calculating your business inventory turnover ratio can result in you missing valuable data that can help you enact your business plan effectively and achieve your goals. Below are different reasons why you should calculate the inventory turnover ratio.
Inventory turnover ratio is a key performance indicator
This is one of the most valuable importance of calculating the inventory turnover ratio in retail businesses. Being a key performance indicator, the inventory turnover ratio can help you manage and grow your business effectively.
It can show liquidity
Do you intend to get a loan to manage your retail business? If yes, you should always calculate the inventory turnover ratio as it will how your business assets liquidity. This will be highly beneficial when making a loan application.
It helps in making business decisions
Making decisions that will benefit your business can be challenging as a business owner. While there are many indicators that you can use, the inventory turnover ratio is particularly peculiar to retail businesses. It shows the stock level and turnover rates which makes making business decisions an easy task. With the inventory turnover ratio, you can answer questions such as:
- What and how many items do you have to order
- What products do you need to put on sale?
Consequently, you can purchase merchandise, and sell products that your customers want. However, do well to combine it with other indicators for maximum business growth.
How To Improve Inventory Turnover Ratio
If on calculating your inventory turnover ratio you find it not in the specified range, then you need to know how to improve it. Below are some ways to improve the inventory turnover ratio for retail businesses.
Get a proper inventory management system
It is impossible to improve your inventory turnover ratio without using the right tools. Therefore, as a retail business owner, you need an effective POS (Point of Sale) inventory management system. These tools will allow you to track sales and inventory levels while generating full reports in
Create ways to sell slow-moving inventory
Another way to improve your inventory turnover ratio is to ramp up sales of your inventory. The problem for many retail businesses that reduces the turnover ratio is
Proper forecasting
Many factors can influence the inventory turnover ratio. These include demand based on season, occasional products, and ongoing market trends. As a result, it is important you properly forecast orders and stock levels yearly, monthly, or quarterly as you like to calculate your inventory turnover ratio.
You can forecast by evaluating sales data as history will most likely repeat itself (depends on your business), observe the trends (for example, if you are dealing with footwear, note the trend on the types of sneakers that the majority of people are wearing and stock on it. You can also forecast based on the season (Christmas toys don’t sell in May). On careful evaluation, incorporate the data into the plan and act on it!
Effective marketing
Your business sales are directly tied to your marketing ability. Consequently, effective marketing is a crucial tool to use when looking to improve your inventory turnover rates. With an effective marketing plan, you can sell items you have in stock that seem unsellable and reach more customers.
Also, marketing can be channeled towards getting new customers. With new customers, you can sell and improve your business and improve your inventory turnover rates. There are many ways you improve your marketing. Below are some ways that have proven effective for many:
Social Media
Social media is a powerful tool, especially when you combine it with the use of ecommerce. You can easily leverage on platforms such as Facebook, Instagram, Twitter, and TikTok for your marketing needs.
Improve your website
User experience is an important factor you should consider also. If your retail business has a website, it is important to improve the website navigation. Consider factors such as loading speed, aesthetics, which improves navigation will affect the number of clicks you get.
Other factors to consider in marketing include email marketing, Loyalty programs, and paid advertising.
Ecommerce
Ecommerce is a powerful tool in the right hands. For retail businesses, you can leverage the advantages ecommerce brings. For example, with ecommerce, you can reach a new and large audience, have access to a different location, etc., to boost sales. There are also other intrinsic advantages of ecommerce based on the platforms you are using. For example, you can use the review system to build up credibility. Improve your sales using ecommerce and consequently improve your inventory turnover ratio.
Final Thoughts
For people running a retail business, your inventory turnover ratio can be an ideal tool to help you measure business growth. It can also be valuable in making business plans to boost sales. To make it easy, this article introduced inventory turnover, how to calculate it, the healthy inventory turnover ratio you could consider, and why it is important. By going through this article, no doubt you have a solid idea on how to improve your sales which banks on the need for a healthy inventory turnover ratio.
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