Inventory To Sales Ratio (Definition And Importance)

Inventory is one of the most valuable assets of a company, but it can also be one of its greatest outlays. To make sure it has enough products to meet consumer demand and prevent excessive inventory, it is vital for a company to keep track of its inventory and sales. Business leaders and executives can benefit greatly from gauging their inventory levels in relation to sales, by using the ratio of inventory to sales. In this article, we examine what the inventory to sales ratio is, demonstrate how you can calculate it and provide an example of a calculation.

What Is The Inventory To Sales Ratio?

The inventory to sales ratio measures how much inventory a business has in relation to the number of sales orders it is currently fulfilling. The ratio contrasts a company's sales, which depends on the price of a product, with the value of its inventory, which determines the costs of individual products. A high or increasing ratio may indicate that a company is hoarding inventory, while a low or declining ratio may indicate that a company is doing well in sales.

Related: 15 Types Of Operations Metrics And Their Use In Business

Why Is This Metric Important?

The inventory to sales ratio is crucial for a business to evaluate its performance and financial health. This metric is critical since a company's inventory is key to sales, while also likely one of its biggest expenses. It is vital for a business to maintain a balance of selling enough products to cover the cost of stocking inventory and maintaining a sufficient amount of inventory items at all times.

This ratio aids in monitoring the rate of sales since companies typically desire to sell their inventory as soon as possible. A company may want its overall sales to be as close to the inventory value as possible. This metric may also be a good indicator of a company's capacity to handle unforeseen challenges. This measurement can assist a business in determining which products to stock, how much to stock and when to restock.

When To Use This Ratio

This metric helps professionals determine a company's rate of sales compared to its inventory stock. A typically good ratio of inventory to sales is less than one and ranges between 1/6 and 1/4. You can express this ratio as a fraction or as a decimal. The nearer to zero the ratio of inventory to sales is, the better the financial health of the company. This indicates that a company has high sales and a low inventory, which might result in a situation where sales exceed the cost of the company's inventory and facilitate the generation of positive revenue.

While a ratio below that range can suggest that stock is selling too rapidly to meet demand from customers, a ratio above that range might imply a weak sales rate. To assess the effectiveness of its inventory stock, a business may decide to regularly monitor its ratio of inventory to sales. The regularity of measuring the inventory-sales ratio is the choice of a business. If a company records the ratio of its inventory to sales over a three to five-year period, it can better understand its selling potential.

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Calculating The Ratio Of Inventory To Sales

You can calculate the ratio of inventory to sales using the average inventory for the time you are tracking and the net sales. You can find the average inventory by adding the starting and ending inventory amounts and dividing that by two. You can calculate net sales by subtracting any sales returns from the total amount of sales. To find the ratio, you may divide the average inventory by the net sales figure. A company can find the numbers to calculate its net sales and average inventory on its income statement or balance sheet.

Example Of Inventory-Sales Ratio Calculation

You can use this example to help understand how to calculate an inventory-sales ratio:

KPN Manufacturing reported sales of ₹6,78,800 in the last 30 days. Two customers returned products for a total of ₹39,940. To calculate its net sales, the company subtracts the returns (₹39,940) from the total sales (₹6,78,800) for a result of ₹6,38,860.

At the beginning of the same 30 days, the company had ₹1,35,790 worth of inventory. At the end of the 30 days, it had ₹23,970 worth of inventory. To calculate its average inventory, the company adds its starting inventory (₹1,35,790) and its ending inventory (₹23,970) and divides that number by two for a result of ₹1,59,760. Now that it has determined its average inventory and net sales, the company can calculate its ratio of inventory to sales. It divides average inventory (₹1,59,760) by its net sales (₹6,38,860) to get a result of 0.25.

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Ratio Of Inventory To Sales As A Key Performance Indicator

The inventory-sales ratio may be among a company's key performance indicators (KPIs). A key performance indicator is a quantifiable statistic that reveals if a business is accomplishing its fundamental goals. A company may use key performance indicators to define its standards of success. KPIs are often precise, quantifiable, achievable, pertinent and time bound. A business can first decide on its end goal, choose how regularly to assess for each indicator and gather existing data to assist in creating a realistic target before establishing its key performance indicators.

Key performance indicators in inventory management assist a company in keeping track of its stock since it can provide insights into inventory sales and demand. An organisation might establish a key performance indicator for its net sales and average inventory targets, and then compare this figure with the ratio of inventory to sales. An organisation may use this comparison to track its progress in relation to its objectives and due dates. Inventory turnover, average time to sell inventory and rate of return are other critical performance indicators in inventory management. Each indicator measures a distinct aspect of inventory and uses a different calculation algorithm.

Useful KPIs In Accounting

Here are some KPIs that accounting departments or experts may use to evaluate the financial health of a company or a department:

Budget variance

Budget variance is a financial metric that assesses actual performance in relation to budgets or predictions. It can also gauge many financial variables like earnings, costs and profitability. Businesses evaluate outcomes based on whether they detect significant or little deviation. Whether it is a negative or positive figure, a big variance can indicate that a company may be required to make adjustments to lower it. The formula for computing this metric is as follows, and you can convert it to a percentage by multiplying it by 100:

Budget variance = (Actual results - Budgeted amount) / Budgeted amount

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Operating cash flow

The operating cash flow (OCF) metric helps companies determine if they can cover regular or necessary operating costs. You can trace cash flow to the operations of a company and it usually appears on the company's cash flow statement. A favourable outcome indicates that a business has enough capital. The formulas for determining operating cash flow are:

Operating cash flow = Total revenue - Operating expenses

or

Operating cash flow = Operating income + Depreciation - Taxes + Change in working capital

Related: Format Of A Cash Flow Statement (With Methods And Examples)

Working capital

Working capital refers to cash that a business has on hand. This assesses a company's capacity for liquidity. It includes the company's current liabilities along with liquid assets including cash, accounts receivable and short-term investments. Businesses can use this KPI to assess if they have enough cash on hand to settle their current liabilities. A substantially high number may also indicate that a company is not efficiently optimising its assets. Low results indicate that a business may be experiencing challenges. This metric's formula is as follows:

Working capital = Current assets - Current liabilities

Related: What Is Working Capital Management? (Importance And Ratios)

Return on equity

The return on equity (ROE) metric compares the net income of a corporation with the shares of shareholder equity. It indicates how much money a business makes for its shareholders. A business can evaluate its profitability and financial effectiveness using this statistic. Companies can track this KPI and compare outcomes at the end of each accounting cycle. The formula for calculating this indicator is as follows:

Return on equity = Net income / Average shareholders' equity