Inventory turnover refers to the amount of times inventory is sold and replaced within a given period, such as a year. Low turnover rates can suggest that stores are acquiring a surplus of inventory, which can mean that they are experiencing problems, while a high turnover rate indicates that a store is doing brisk business. Inventory turnover is one of the many metrics used to gauge the financial health of companies large and small, and business owners may periodically assess their inventory turnover to see how they are doing.
Two different formulas can be used to arrive at inventory turnover numbers. In the first, people divide the cost of sales by the inventory. However, this method can be flawed because inventories are usually expressed in wholesale value, not in retail value, which means that the result of this equation will be skewed. Instead, some people prefer to divide the cost of goods sold, reflecting the price paid by the company, by the average inventory. Using an average inventory avoids skewed results caused by seasonal changes, such as radical differences in inventory which appear in November and December in many regions of the world.
Sometimes, the rate is low because a company is stocking up on goods in preparation for a big event, in which case the company may be perfectly healthy despite the fact that it has a low inventory turnover ratio. Conversely, extremely high rates can serve as an alert that a store may not be keeping adequate supplies in stock, and the consumers could be growing frustrated with a lack of options caused by poor inventory management. Companies must seek a balance when managing their inventory, using their funds wisely to generate the best returns.
People managing their inventories must also think about how they are going to allocate funds. For example, a company could buy a very large batch of a particular item, tying up capital in inventory until it sells, or it could buy a small batch, use the funds from that sale to buy another small batch, and so forth, thereby freeing up funds for other uses. Keeping too much costly inventory on hand can be a bad idea for a company which needs financial flexibility, as it may be forced to sell off the inventory quickly to raise capital.
Inventory turnover also reflects consumer interest in the products a company is selling. If a company experiences a high turnover rate which gradually slides into a low one, it suggests that consumer interest may be cooling, and that it is time to make some adjustments to the inventory. Conversely, if a company's turnover rate suddenly starts to skyrocket, it means that there has been a spike in consumer interest which should be addressed.