Jeff's inventory balance for the previous month was $24,000, and the total sales amount for that same month was $9,600. Jeff's inventory to sales ratio is 2.5 and was calculated as:
Using the inventory to sales ratio
At first glance, the inventory to sales ratio might seem too simple to yield any useful information. But when reviewed on a month-to-month basis, the inventory to sales ratio can signal potential problems in your cash flow. For example, an increase in your inventory to sales ratio from one month to the next indicates that one of the following is happening:
- Your investment in inventory is growing more rapidly than sales
- Sales are dropping
No matter which situation is causing the problem, an increase in the inventory to sales ratio may signal an oncoming cash flow problem. Likewise, a decrease in the inventory to sales ratio from one month to next indicates that one of these is occurring:
- Your investment in inventory is shrinking in relation to sales
- Sales are increasing
Here again, no matter which situation is causing the reduction in the inventory to sales ratio, either one suggests that you are effectively managing your business's inventory levels and its cash flow.
Inventory investment and turnover analysis
Turnover analysis is the most basic and fundamental tool for controlling your investment in inventory. The process looks at your business's investment in individual items or groups of items making up your entire inventory. Turnover analysis then helps you decide if your investment in an inventory item, or groups of items, is excessive, too low, or just right.
From a cash flow perspective, performing turnover analysis is particularly useful for finding inventory items that are over-stocked. Remember, an excessive investment in inventory results in less cash available for other cash outflow purposes, such as paying bills.
Since turnover analysis focuses on individual inventory items or groups of items, it requires that you make a periodic count of all the items making up your total inventory. Your business probably already takes a physical count of its inventory items, so the information necessary to perform turnover analysis may already be available. If you are just beginning your business, be prepared to make a periodic count at least once a year, if not more often.
Turnover analysis also requires that you know the number of inventory items sold on an individual basis. This may seem like an awful lot of work just to determine if the investment in a particular inventory item or group of items is excessive. However, the information provided by the analysis will make it all worthwhile.
Analyzing turnover vs. average inventory
There are some limitations to the information provided by the average inventory investment period calculation. First, as the name implies, the average inventory investment period is an "average." Because it is an average, it assumes that all products are the same, each selling at the same rate, and each costing the same amount. Secondly, the calculation assumes that your inventory only contains one product. Most likely, your business carries a number of different products; some selling faster than others, and others costing you more to purchase.
Turnover analysis goes beyond the average assumptions made by the average inventory investment period. It does this by requiring you to look at each product or line individually, taking into account the number currently on hand, the number sold and the number on hand in relation to the rate at which each item sells. So, turnover analysis can be used to pinpoint the specific inventory items that are creating an excess investment in inventory, thus creating cash flow problems.
Using turnover analysis
Turnover analysis helps you decide if your investment in a particular inventory item or in a group of items is excessive, too low or just right. From a cash flow perspective, performing turnover analysis is particularly useful for finding inventory items that are over-stocked.
Remember, an excess investment in inventory results in less cash available for other cash outflow purposes, such as paying bills or meeting payroll. Pinpointing inventory items held at excessive levels, and reducing those levels helps reduce your total investment in inventory. Reducing your total investment in inventory helps improve your cash flow.
Performing turnover analysis requires you to look at each individual inventory item for the following information:
- The number of items currently held in inventory
- The number of items sold during the measurement period (expressed in days, Generally 30 to 60 days)
- The number of items held in relation to the measurement period
Once the information is compiled for each inventory item, you can then determine if the level for each item is excessive, too low or just right. In some cases, you may want to save time by using departments or product lines rather than individual items for your initial turnover analysis. If you find a department or product line that's causing trouble, you might go farther and do a turnover analysis of each item in that grouping.
Case study: Turnover analysis
Turnover analysis allows you to determine if the inventory level for each individual inventory item is excessive, too low or just right. This example shows an inventory analysis turnover schedule, and how the information can be used.
Jeff Hammer, owner of Handy Hardware, has been experiencing some cash flow problems, causing him to draw on the store's line of credit at the bank more than he was expecting. Jeff has noticed a significant buildup in the inventory of the home repair and improvement section of the store. Sales in this department have remained steady, but the average inventory investment period and the inventory to sales ratio have both increased over the last three months. Jeff's goal is to stock the number of inventory items necessary for about 30 days of sales.
Jeff has decided to perform a turnover analysis on the home repair and improvement inventory items. He has just completed his mid-year physical inventory count so the number of items held in inventory is already available. The number of a particular item sold was compiled using information gathered at the time a customer checks out. The following is an excerpt from his turnover analysis schedule: