Believe it or not, how you manage your inventory affects how much cash your small business generates daily. If you’re mismanaging your inventory, you’re putting yourself at a disadvantage. A higher turnover ratio has a better impact on your cash flow. But how do you know where to start?
Calculate your inventory turnover ratio.
Simply put, inventory turnover is how often you sell and replace your inventory over a certain timeframe. Each industry, and in fact, each category of merchandise, has an average turn rate for that type of product.
To calculate your turnover ratio, divide the cost of products/services sold for a period by the average inventory price for that period. Average inventory (the average of your beginning and ending inventory) is used to accommodate the various merchandise fluctuations of many small businesses. Your company might only purchase once a year and sell throughout the year or you might purchase inventory throughout the year. Average inventory accommodates for both circumstances.
For example, let’s say you own a retail shop. In the last year, you’ve sold $10,000 worth of goods. You purchase your inventory throughout the year, and your beginning inventory is $1,000 and ending inventory is $3,000. Your inventory turnover ratio would be five times. You can calculate it as follows:
(Turnover Ratio) = $10,000 / (($1,000+$3,000)/2))
(Turnover Ratio) = $10,000 / ($4,000)/2)
(Turnover Ratio) = $10,000 / $2,000
Turnover Ratio = 5
Because your inventory ratio is five times, it means it takes roughly three months for you to sell your inventory (365 days / 5 = 73 days). Let’s say your turnover ratio is two times. This means it takes roughly six months to sell your inventory. The lower your turnover ratio, the more reduction in cash flow. If you’re buying more inventory faster than you’re selling it, you don’t have good inventory control.
Diversify your business to help your turnover.
Offering new products or services can help you increase your turnover ratio. Customers like seeing a variety of options. If they see the same products/services every time they come to your store or website, they won’t get that sense of urgency to make an immediate purchase. Purchasing new items or offering new services keeps them interested in your business while also fulfilling another need they may have. Going back to retail, let’s say you sell the same tank tops every month. Even by purchasing them in different colors each month, you’re making your displays more exciting and enticing for the customer to purchase your items.
Be smart with your basics.
However, it’s important to be smart about how much inventory your purchase. You don’t want to purchase too much of one item and resell any leftovers a year later. While it seems like a good idea and can be easier to get from vendors, it can unnecessarily hurt your cash flow in the long run.
For example, going back to the retail store, let’s say you also sell black turtlenecks. You purchased these for $10 each and sold them for $25 each. At the end of the season, you see you have two dozen left in stock. Rather than marking them down, you might put them in storage for the next winter season, thinking it will save you some extra money. However, this isn’t the best route to take. Instead, you should take these two dozen turtlenecks and mark them half off. Once they’ve sold, you will be left with $300 to buy new products.
With proper management, your inventory is your greatest asset. If you manage your inventory turnover ratio well, you’ll see the positive effect it has on your cash flow. If your turnover is low, don’t fret. Even by increasing your ratio just a quarter of a point, it can have a big impact on your cash flow. Over time, and with proper strategic planning, you may be able to increase your turnover ratio even more.
Allison Boswell started her career as a buyer for a department store chain in 1978. After managing the Limited’s flagship store in San Francisco, she was offered a position as a sales rep, which gave her an entirely different perspective. It was here that she first worked with independent retailers and saw a tremendous need for education. As a result, she started her own retail consulting business in 1985. In addition to consulting, she has lectured and written articles for various retail trade publications. Allison joined Management One™ as part of the Reedy Consulting and Analysis™ team in February of 2010. Allison also enjoys problem-solving with her clients in areas other than planning including employee compensation and training, social media, marketing and vendor relations. She is proud to have clients that have been working with her for as long as 27 years. As one of Management One’s™ top consulting teams, Reedy Consulting has won a number of awards including “Best Client Retention” and “Highest Annual Sales”.