An inventory turnover ratio is an important ratio that helps in analyzing the frequency of sales and inventory replacement taking place within a specific time period and, accordingly, helps in making decisions. For example, An inventory turnover ratio of 5 for A Ltd means the inventory of A Ltd is sold and replenished 5 times a year on average. So, today, we will deal with a very common question associated with inventory turnover, i.e., What is a Good Inventory Turnover Ratio? This question scratches the minds of a retailer or traders, manufacturers, financial analysts, students of the commerce and finance streams, etc.
What is a Good Inventory Turnover Ratio?
Generally, it is difficult to be precise in giving an exact ratio because the industries differ from each other in terms of size, product, etc. Moreover, it is believed that the inventory turnover ratio is good when it is as high as possible. For small industries, a ratio between 2-4 might be considered good, whereas for huge industries, a ratio between 5-10 might be considered good.
The obvious answer, i.e., as high as possible, may not always be the correct answer. We will discuss some reasons for it. Or in other words, we will see what can go wrong when you have a high inventory turnover ratio. There are various ways by which you can increase the turnover ratio.
Allowing heavy discounts, you can increase sales significantly and, in turn, the inventory turnover ratio too. But, we tend to forget that our objective of running a business is not sales maximization but it is profit maximization. Are we really achieving it through our action of discounting? Let’s check with an example.
Assume you are selling an Item X at $15, and its cost is $ 10. In the normal course, you are able to sell 100 items in a month. You thought you should increase the turnover of this item and decided to offer a discount of $3 (~ 20% on sales). And, you were able to more than double the turnover, i.e., 220. Look at the end results.
|Before Discount||After Discount|
Your strategy to offer discounts worked absolutely well to increase the sales numbers. But, the profits decreased. This shows that just increasing turnover would seldom make any sense. Let’s look at another table below for an optimal level of discount that would keep the focus on maximizing profit and improving inventory turnover.
|Increase in Sales||0.0%||25.0%||75.0%||100.0%||110.0%||115.0%||120.0%|
We see that we offered a 20% discount to achieve a sales 220 units but resulted in overall profit decrease by 60 (500-440). If the discount were 12.5%, making the sales at 200 units, we would have made a profit of $625, an increase of $125 from the current $500. We noticed here that with lesser sales, we had more profit. Therefore, it is important to strike a balance between the turnover ratio and profitability.
Stock Shelf Life
Another very crucial factor to take care of is stock shelf life. In the above example, the priority was profitability first and then turn over till the last piece of stock. When you know that the stock will be a dead stock or will become obsolete, the priority changes after a point of time to sales first and profitability later. Suppose the product is milk that will perish in 4 days, and you are sitting on the 3rd-day end. Priority will change if you have more stock than what you can sell on the 4th day. Here, on the 4th day, you should even sell the milk at half its cost to recover the invested capital. Else, you are at risk of losing your capital; leave the thoughts of profit.
Holding Costs / Carrying Costs
Both holding and carrying costs of inventory impact the decision relating to inventory. Whether to hold or move with lower profitability. Inventory holding costs increase when the turnover is low and decreases when the turnover is high. Take the example of warehouse rent. Suppose you have taken on rent a warehouse @ $10000 per month and you sell water purifiers @ $1000, and its cost price is $920. Your contribution per purifier is $80. Recalling the concepts of marginal costing,
Breakeven sales = $10000/$80 = 125 Units.
This means if you sell 125 units, your per-unit cost of warehouse rent would be $80. To earn out of your venture, you need to sell a minimum of 125 units. If you sell 1000 units, your per-unit holding cost is only $10. Although to sell more, you may have to compromise on the margin either through discount or additional marketing. Similar to the example of the discount above, you need to establish an optimum solution.
FULL RATIO ANALYSIS (32 RATIOS)
We have covered the complete ratio analysis – its significance, application, importance, and limitations, and all 32 RATIOS of ratio analysis that are structured and categorized into 6 important heads.
Keep reading Inventory Turnover Ratio.
In essence, the question “what is a good inventory turnover?” can be best answered as below:
A good inventory turnover ratio is one that sustains
- Saves stock from becoming a deadstock
- Optimizes Holding Costs / Carrying Costs