How do you define inventory?
Before we get into the nuts and bolts of inventory management, let’s define inventory. For companies that sell finished products, inventory is the account of all the finished goods a business holds in its stock that will be sold at some time in the future. In addition, inventory can also include raw materials and components that are used to make finished goods. For example, the wood used for making furniture is inventory for a furniture manufacturer.
What is the inventory turnover ratio and what does it mean?
Inventory is simply the number of times a business sells and restocks goods during a specified period. We use the inventory turnover formula to calculate it:
Inventory turnover ratio = cost of good sold during a period ÷ average inventory for that period
The cost of goods sold (COGS) measures a company’s cost to produce goods and services. Amounts included in COGS can include labor costs directly connected to the goods or services, materials costs, fixed costs and other overheads that are directly used in the production of goods.
The ratio includes average inventory because inventory levels will vary at different times of the year. For example, consumer-focused retailers will have high levels of inventory leading up to the Christmas period in the second quarter and low inventory levels during the third quarter of the financial year.
Let’s say we want to calculate the inventory turnover ratio for a business during a year. The average inventory for the year is $65,000 and the total cost of goods sold is $550,000. Given these figures, the inventory turnover calculation is:
$550,000 ÷ $65,000 = 8.46
This figure tells us that the inventory turns over 8.46 times during the year.
When we have this result, we can calculate days sales inventory (DSI) which measures how many days it takes on average until the inventory is sold. The formula to calculate this is:
(Average inventory ÷ Cost of goods sold) x 365
From the scenario above, this will be:
($65,000 ÷ $550,000) x 365 = 43.13 days
This means that, on average, the business holds the inventory for 43.13 days before it is sold.
These ratio calculations can be applied to various items of inventory to see how well they move.
Why is the inventory turnover ratio important?
Knowing the amounts of a company’s inventory is important for managing a business and cash flow. Inventory has a holding cost that can include the interest used to finance it and storage costs. If there’s a large gap between the purchase and sale of inventory (a big DSI), cash flow will be negatively impacted. What determines a good day’s sales of inventory will depend on the type of product. For example, a luxury product with a higher margin can have a larger DSI and still be okay. Smaller, less expensive products with smaller margins need to turn over more quickly. Regardless of the type of business, ‘dead stock’ that isn’t moving quickly enough lowers the financial health of a business. This problem can be uncovered using the inventory turnover ratio.
Inventory turnover effects on financial statements
Although inventory shows up on the balance sheet as an asset, having too much inventory that isn’t being sold will have a negative impact on the income statement (profit and loss statement). The bottom line will be affected as increased inventory expenses aren’t balanced by an increase in sales, resulting in less profit (or a loss) for the business. Understanding the inventory turnover ratio will help you avoid these negative impacts.
Solutions for financing inventory
The gap between purchasing inventory, selling it and getting paid can cause cash flow shortages. Unsecured inventory finance is one way to overcome the cash flow challenges of holding inventory.
Buy now, pay later is another way for businesses to finance inventory purchases. Moula Pay is an innovative finance solution that makes it possible to finance business-to-business transactions, including inventory purchases. With Moula Pay, businesses can enjoy twelve months to pay off business purchases, with the first three months free. Find out more about The Benefits of Buy Now, Pay Later for Business.