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Demystifying your Accounts - Inventory Turnover

Written by Rory Noorland.

 

Inventory turnover

A set of financial accounts can provide far more than a simple report on the profit or loss your business has made. Digging a little deeper and running some relatively simple equations can provide an insight in to the strength and health of your business.   There are many tools and measures to assist you in ‘Demystifying your accounts’ to convert the information contained in  those financial statements into some useful insights into your business.

For the third article of our series we will look at a measure of how quickly your business is moving its inventory

Inventory turnover ratio
 

Inventory for many businesses is the main source of revenue, through the manufacturing or purchasing of goods, adding a margin and then on selling for a profit.  Although sounding simple, the management of inventory can be overlooked when analysing the performance of a trading business. 

The purchasing of inventory represents a cash cost to the business and although considered a current asset can quickly become a burden if not managed appropriately.  When looking at the value of inventory in your financial statements there are a few key points that you should consider:

  • Is all of it current or saleable?
  • How long will it take to sell?
  • If old how much will it sell for? More or less than it cost?
  • Should some be written off?

Much like the accounts receivable turnover ratio which is a measure of how quickly, on average, it is taking for your credit customers to pay you, the inventory turnover ratio measures how long on average you are holding inventory before it is sold.

The formula to work out this ratio is:

             Total sales ÷ average inventory

Again the ratio can be determined on a monthly or yearly basis the period over which the sales and inventory are measured needs to be the same.  If you are using opening and closing inventory from the annual accounts then you need to use the total sales for that class of inventory for the year as well.  Likewise if you are measuring the ratio for a particular month it would be the average inventory for that month and the total sales for that month only.

To work out the average inventory add the opening and closing balance for the period and divide by two.

Dividing your sales by your average inventory will give you a ratio.  Dividing 365 by the result of the formula will give you the average number of days it takes to sell your inventory. An example of this is as follows:

Example 1
 

Sales for the year (1 April 2016 to 31 March 2017)                             $800,000

Opening inventory (1 April 2016)                                                            $50,000

Closing inventory (31 March 2017)                                                         $100,000

Average inventory                    = (50,000+100,000) ÷ 2                        = 75,000

Inventory turnover ratio                       = 800,000 ÷ 75,000                    = 10.67

Average duration of holding inventory = 365 ÷ 10.67                          = 34.2 days

 

The larger the inventory ratio, the longer your inventory is being held. This translates to a longer period of time that cash is being locked up in your business. Furthermore, this could also reduce the ability for you to sell that item for the full profit you were expecting in the future due to changing market condition. 

It is also possible to undertake the same analysis on each class of inventory.  Breaking sales and inventory levels down to a categorical basis allows for an analysis of what inventory you are possibly holding too much or too little of.

There may be some types of inventory that you can hold very few items of. For example,  if you have slow moving stock you may wish to hold only one or two items or alternatively you may determine you require high levels of certain inventory items as they may sell faster than you are able to manufacture or have supplied to you.

This can be taken a step further and plotted over time, i.e. month to month. This allows for seasonality trends to be identified, meaning that inventory levels can be managed to ensure that the excess inventory is avoided and that you hold enough of those items of inventory that can be readily turn into cash and profit.

For more information please contact Rory Noorland on 07 889 8850

 

 

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