Mariam Furmanau and David Hall | In our last article on inventory management we listed questions that you should ask to better understand and manage your inventory. Now that you’ve found a system that works for you, what’s next? Let’s talk about ratios! Inventory ratios help with measuring and managing your stock levels so you can improve your business’s performance, cash flow, and profitability. In this piece, we’re going to tell you about four key inventory ratios.
Inventory Turnover Ratio
Inventory Turnover Ratio is the most commonly used and perhaps most important inventory ratio. It tracks the number of times a business cycles through its inventory in a given time period.
Inventory Turnover = Cost of Goods Sold / Average Inventory
For better insight, use shorter periods like quarters, months, or even weeks. Yearly inventory turnovers often don’t work for small businesses because they tend to make smaller and more frequent purchases to respond to consumer demands while tightly managing cash flow. The best practice is to start big and then get specific. Start by calculating turnover for your entire inventory, then zoom in on specific product categories or individual products. Doing that will tell you which products sell faster during certain parts of the year, when to replenish certain products, and when to discount others.
The denominator, Average Inventory Value, is also an inventory ratio, although it is rarely used as such, and delivers little insight on its own. You may find yourself calculating it if, for example, you are running a detailed investigation of inventory losses. Average Inventory Value is generally estimated using the value of the inventory at the beginning and at the end of the period considered:
Average Inventory Value = (Beginning Value + Ending Value) / 2
Gross Margin Return on Investment
The Gross Margin Return on Investment, or GMROI, helps determine whether a company is able to make a profit on its inventory. In other words, it shows how much you make on every dollar you invest. While this ratio can be applied to your entire inventory, it is most useful when calculated by product category or product line.
Gross Margin Return on Inventory = Net Sales / Average Inventory x Gross Margin
where Gross Margin = (Net Sales - COGS ) / Net Sales
Say you sold ceramic bowls and your net sales were $75,000, your average inventory was $30,000, and your gross margin was 50%. Your GMROI would be $1.25, and that is how much you would be making for every dollar invested in your inventory. Combining the GMROI with other ratios, like the Holding Inventory Ratio (see below) and Inventory Turnover Ratio (see above), you can determine how profitable a product is, how many days you can hold onto that product before you begin to lose money, and how quickly you need to sell the product to meet your financial goals.
Holding Inventory Ratio
The Holding Inventory Ratio helps you assess the costs of carrying inventory before selling it. Holding costs normally include storage, labor, security, insurance, and associated equipment. Typically, they represent 20% to 30% of inventory value, but this will vary by industry and company.
Holding Inventory Ratio = Holding Costs / Average Inventory Value
Calculating the Holding Inventory Ratio can help you choose between different inventory system options, as well as strategize for seasonal fluctuations to ensure that you are stocking the right amount of products to optimize your cash flow.
Days Sales of Inventory Ratio
Days Sales of Inventory Ratio, or DSI, calculates how many days a company holds on to inventory before selling it.
Days Sales of Inventory = Average Inventory / Net Sales x # of days in a year
DSI results vary greatly across industries and can be misleading without context. Also, DSI is most useful when combined with other ratios, specifically the Inventory Turnover Ratio and Holding Inventory Ratio. Knowing how many times you sell and replace inventory in a period, paired with how many days on average you hold that inventory and its holding costs, can provide a more comprehensive picture of your inventory cash requirements.
So, now you have information produced by inventory ratio equations, what next? The real value of inventory ratios is viewing them in the right context and continuously using them to find performance trends, sales spikes, and lulls. Evaluating inventory regularly will help keep your inventory, one of your most important assets, from becoming your largest liability.