Inventory Turnover Ratio: Why keeping track is very important for small business owners

Inventory Turnover Ratio: Why keeping track is very important for small business owners

No matter what type of small business you run, managing your inventory correctly can be extremely difficult.

If you run a restaurant that serves perishable foods, if you order too little inventory your customers will be dissatisfied and you won’t fulfil your potential in terms of how many sales you generate. But if you order too much food, you will find yourself with space wasted, money wasted and food wasted.

Understanding your business’s inventory turnover ratio can help you more accurately manage your inventory. To understand what the inventory turnover ratio is, it is necessary to break down this term to its components:

  1. Inventory: The goods available for sale and raw materials used to produce goods available for sale. Inventory represents one of the most important assets of a business because the turnover of inventory represents one of the primary sources of revenue generation and subsequent earnings for the company’s shareholders.” (Investopedia)
  2. Turnover: “An accounting term that calculates how quickly a business collects cash from accounts receivable or how fast the company sells its inventory.” (Investopedia)
  3. Ratio: “The comparison of [two] or more quantities which indicates their relative sizes.” (ThoughtCo)

Thus, your inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing cost of goods sold with average inventory for a period. It measures how many times a company sold its total average inventory dollar amount during the year. Therefore, a company with $20,000 of average inventory and sales of $100,000 effectively sold its inventory five times over giving it an inventory turnover ratio of 5.

Take a 360 degree view of your business when making inventory decisions. Let’s say you own an auto repair shop that focuses on giving your customers new tires. There are many factors you might consider when making new tire orders:

  1. Suppliers: You must consider if there will be deals or specials from your suppliers given at different times of the year as well as the delivery speeds.
  2. Storage: You must know how much space you have to store your inventory.
  3. Waste: You must consider what percent of tires you receive will be duds that you will have to ship back to the supplier.
  4. Sales estimates: You must look at past sales data to determine which months of the year are most popular for people to purchase new tires.
  5. Discounts: You must factor in if you will offer sales or discounts to your customers.
  6. Timelines: You must evaluate which types of tires are more popular at different points of the year (e.g. snow tires vs. all-season tires.)
  7. Numbers: You must also consider what percent of your customers need one tire replaced (e.g. for a flat tire) rather than changing all four tires on their vehicle.
  8. Growth: You must calculate how fast (or slow) your business is growing.
  9. Trends: You must calculate market trends (e.g. if big winter tire companies are advertising their services, more of your customers may ask for these.)
  10. Competition: You must figure out what your competitors’ strategy is (e.g. if a shop down the road offers to change one tire for $30, you may want to focus your business on selling four-tire packs.)

There are many methods to making sure that you’re inventory is working for you. Perhaps the most important method is called First In First Out, or FIFO, if it is abbreviated. As Casandra Campbell writes about it for Shopify, “It means that your oldest stock (first-in) gets sold first (first-out), not your newest stock. This is particularly important for perishable products so you don’t end up with unsellable spoilage. It’s also a good idea to practice FIFO for non-perishable products. If the same boxes are always sitting at the back, they’re more likely to get worn out. Plus, packaging design and features often change over time. You don’t want to end up with something obsolete that you can’t sell.”

Another important principle to remember is to set “par levels.” Campbell writes:

“Make inventory management easier by setting ‘par levels’ for each of your products. Par levels are the minimum amount of product that must be on hand at all times. When your inventory stock dips below the predetermined levels, you know it’s time to order more. Ideally, you’ll typically order the minimum quantity that will get you back above par. Par levels will vary by product based on how quickly the item sells, and how long it takes to get back in stock.”

Furthermore, remember the 80/20 rule often still holds true: 80% of your business comes from only 20% of your inventory, 20% of your customers, and 20% of your suppliers; however, knowing this, remember to have alternate suppliers ready in the event one of your key suppliers messes up an order or is out of stock.

Keeping an accurate count of your inventory, and correctly predicting your future needs are excellent ways to save your business money. Wasting money on unused inventory is costly and can easily be prevented. Knowing your inventory turnover ratios for each specific item that you require to operate your business are excellent ways to make sure you properly account for your inventory, saving your business both time and money.

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