Editor’s Note: This is one of an eight-part series about key financial terms all business owners should know.
Any entrepreneur who’s worked in retail knows that a misstep in inventory can cost the company money; and getting caught with obsolete inventory when consumer tastes change can spell major trouble for an otherwise-thriving business. Ask anyone whose company is sitting on inventory of fidget spinners or Snuggies. It’s no wonder, then, that would-be investors often take a close look a business’s inventory turnover ratio (ITR) before making funding decisions. Here’s a quick primer on ITR, why it’s important, and how one expert CFO recommends business owners keep the ratio in check.
What is inventory turnover ratio?
ITR is a measure of how efficiently a company is managing the goods in has in stock. ITR is calculated by dividing either sales or cost of goods sold (COGS) by average inventory — depending on your industry’s standard practice. The latter method does not take markups into account, so investors may consider it a more accurate representation of true cost. When divided by the number of days in a given period (month, quarter, year, etc.) a company can quickly tell how many days it is taking, on average, for inventory to “turn,” or sell.
Why is inventory turnover ratio important?
Having too much inventory on hand — or having the same inventory on hand for too long — may be detrimental for a business. Not only does it tie up capital, but it also creates a potential liability as inventory is less liquid than other assets.
Depending on the business, inventory may spoil (groceries or imported luxury food products), go out of style (fashion or fad items), become obsolete (tech products), or otherwise lose value based on how long it is stored. Plus, warehousing excessive inventory can be an expensive line-item. A business’s ability to forecast demand correctly and move through its inventory efficiently can be critical to success.
How can inventory turnover ratio impact your ability to raise capital?
The faster a company turns over inventory, the more successful (and often profitable) it is likely to be. Although there are industry exceptions (ultra-luxury purchases like high-end sports cars and real estate properties), investors often look for companies with products that are in-demand. If you’re considering raising capital in the near future, understand your inventory turnover before you enter into serious discussions. It may be prudent to offer a one-time sale or discount on existing inventory to improve your turnover ratio and decrease the amount of assets tied up in inventory.
Ask an Expert
Even if entrepreneurs have never heard of ITR before, they likely have an intuitive sense of how their inventory is turning. Strategic Funding asked Brad Shanahan, COO/CFO of VitaPerk, the world’s first nutrient coffee enhancer, why ITR is so important for business owners to keep an eye on at any stage.
Why is calculating the ITR — and keeping an eye on it — important?
ITR is important because a company often has a significant amount of money tied up in inventory. If the items in inventory do not get sold, the company’s money will not become available to pay its employees, suppliers, lenders, etc. It’s also possible that a company’s inventory will become less in demand, obsolete, or even deteriorate. If that occurs, the company’s money will be lost. Having slow-moving items in inventory also uses valuable space and makes the warehouse less efficient.
How often should businesses be calculating their ITR? Does it vary based on where the business is in its lifecycle?
In my opinion, a company should calculate their ITR on a quarterly basis (for a rolling 12-month time period), whether an early-stage startup or an established business.
A key to success as an entrepreneur is never being afraid to admit what you don’t know. Don’t know as many financial terms as you’d like to? No problem! We’ve got you covered with the next installment of this series, where you will learn everything you wanted to know about payable turnover ratio. And don’t forget to check out our previous installments on debt to income ratio and current ratio.