Most business owners I meet have a glazed look wash over their faces when I start asking questions about “financial ratios”. The most common response is something like: “Well…I can’t be sure…things move so fast around here. My book-keeper gives me a P & L every month – and as long as it looks good, I don’t waste time on analysis…I just keep doing more of what I do best”.
Does this sound like something you may have heard – or something you may have SAID lately??
Every business goes through cycles of peaks and valleys. Do not fool yourself into thinking a downturn will never happen in your business. Sometimes even the smallest market shifts can create tremendous upheaval to your business. Being prepared to address these “shifts” will not only help you navigate the rough water, but quite possibly could position you for competitive market dominance. That being said – let’s dive into PART 1 in a series of posts on Financial Health – “Getting to Know Your INVENTORY TURNOVER RATIO”.
Your inventory turnover ratio is one of the most important financial ratios to monitor and manage. Of all the asset management ratios, it gives you, the business owner, some of the most important financial information. The inventory turnover ratio measures the efficiency of the business in managing and selling (turning) its inventory. This ratio measures the liquidity of your inventory. It also helps determine how you can increase your sales through inventory control…more on that later. Make note of this – the calculation for the inventory turnover ratio:
Net Sales $ / Inventory $ = # Times (ITR)
In order to calculate this ratio, you can use the net sales dollars from your company’s income statement and your inventory valuation dollars off your balance sheet. If you use a cloud-based inventory management tool, like ChannelAdvisor Premium, you could just do a quick look up / export from your sales and inventory views to get this data at a moments notice – this is VERY powerful when you need to make quick decisions on Buying or Selling strategies!
Ok – so you have your turn ratio – now what? – Let’s do some basic interpretation.
Generally, a high inventory ratio means that your company is efficiently managing and selling its inventory. The faster the inventory sells, the less cash the company has tied up. However – if you are selling closeouts or using drop ship services – high inventory turnover can present a danger in that it can often lead to stock oversells.
If your company has a low inventory turnover ratio, then there is a high probability that you are holding obsolete inventory which may be difficult to sell. This often erodes your company’s profit – creating the oft cited phrase, “…where is it all going??!”. Keep in mind – you may be holding bulk inventory for legitimate reasons. This is often the case for retailers who are preparing for the holiday season, among other valid reasons.
It is important for you to understand *why* the inventory turnover ratio is high or low. In order to do that, you need to look at the company’s investment in inventory and determine what inventory is being most productive. This brings us back to the question of how analysis like this can help increase sales. Here is a real-life example:
If you have the ability to create a spreadsheet that lists all of your SKU’s, with unit cost basis, qty in stock, qty sold and net sales – you have absolute GOLD at your fingertips! A couple of quick formulas will give you total inventory value in dollars and total sales in dollars – thus your basis for your Inventory Turnover Ratio. Let’s say it produces a ratio of 4.27. Now what?
* Once you have recorded this ratio, keep it charted so you can use it for comparison later…How does 4.27 ITR stack up against:
- how I was doing last month?
- last year at this time?
- against industry averages?
Next, you may take a look at some of the individual SKU’s for comparison. What five SKU’s am I carrying the most of? The individual ratios for these SKU’s should be higher than that of your total ITR. If they are equal or lower – chances are they are MAJOR dead-weight, or represent significant risk should there be a market shift of some sort. This same logic can be broken down and applied by marketplace: What is my ITR specific to my:
- Website sales?
- eBay store vs eBay auctions?
- Amazon sales?
- Buy.com sales?
A concerted effort to tighten your ratios on these will have a long term positive effect on your bottom line!
Unfortunately, I can’t dive deeper here – since every business is going to have nuances that can’t be captured in a little blog space… But feel free to post questions or email me with specifics, and I would be happy to help you take advantage of the data you have to make your business even stronger. Bet you can’t wait for the next installment in this series…the Quick Test…the Financial Ratio. If you REALLY ARE excited…then you (like me) just passed the NERD TEST 🙂