Inventory turnover rate calculates how many times a company replaces its inventory to generate sales in a given period. It helps manage inventory levels and determine how much cash should be tied up in inventory. Calculating the rate allows a business to determine the smallest amount of inventory needed and how many times it needs to restock to achieve desired income levels. This frees up working capital for other initiatives.
An inventory turnover rate is a standard financial calculation that determines the number of times a company replaces its inventory to generate its current level of sales in a given period, usually 12 months. The formal calculation is the cost of goods sold (COGS) for the year divided by the average investment in the company’s inventory. Average inventory is calculated by adding the company’s beginning and ending inventory value for the year and dividing by two. The inventory turnover rate allows a business to properly manage its inventory levels and determine how much of its cash should be tied up in inventory at any given time.
Running a business involves a complex assessment of how best to use available resources to ensure stability and growth. A wrong decision can quickly lead to the end of a business. Lack of liquidity means that the company cannot react to opportunities in the market or position itself to increase market share and increase revenue.
One of the key elements of resource allocation is inventory management. Inventory tends to be a company’s largest single investment. Calculating a company’s inventory turnover rate allows you to understand how much inventory should be on the shelf at a given time of year. If the company buys all of its inventory needs at the beginning of the year and sells it slowly during the year, its turnover rate will equal one. While this sounds like a productive way to manage inventory by paying for all the necessities at the start of the year, it actually hurts the business by hoarding cash on inventory that may not sell until the end of the year.
The best course of action is to determine the smallest amount of inventory the business needs to keep on hand and the number of times it would need to restock its inventory during the course of the year to generate the same revenue as buying all of the inventory at the beginning. This is where the inventory turnover rate comes into play. The ratio takes the COGS and divides it by the average inventory investment for the year. Thus, the formula allows the company to determine the highest number of inventory turnovers that it can support during a year and still achieve the desired income level.
With the inventory turnover rate, a business might determine that it can rotate its inventory four times a year and still achieve the same levels of income that it would achieve if it bought all of its inventory in advance, for example. Operationally, this means the company would only need to spend a quarter of its inventory budget at the start of the year. This frees up working capital for the company to pursue other initiatives rather than having cash sitting on inventory shelves.
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