Inventory to sales is an efficiency ratio that is used to determine the rate at which the company is liquidating its inventory. Put simply, the inventory to sales ratio measures the amount of inventory the company is carrying compared to the number of sales that are being made.
This ratio alerts managers when stock resources are going down to ensure stable operations are maintained.
Inventory management is a pain point for managers operating in an economy with fluctuating market demands and this ratio can help to establish a balanced relationship between the company’s inventory and the corresponding sales of goods. Unpredictable changes in the demand of a product can make the inventory last longer, forcing the firm to incur an extra storage and maintenance cost which will end up eating into the firm’s profit.
Efficient maintenance of inventory is a crucial aspect when running a business because when you keep a large stock, then you risk not selling them hence reducing the efficiency of the business operations. To this end, for efficient operation to be maintained, firms need to keep their stock in such a way that it never has either too much or too little of it in stock as efficiently maintaining inventory.
Inventory to Sales Ratio Formula
$$\text{Inventory to Sales} = \dfrac{Average\: Inventory}{Net\: Sales}$$
Net sales is calculated by subtracting any sales the company returns from the gross sales.
Average inventory is used so that any seasonality effect is covered and can be calculated by summing the beginning and ending inventory and dividing the result by two.
$$Average\: Inventory = \dfrac{(Beginning\: Inventory + Ending\: Inventory)}{2}$$
All of the numbers need to calculate net sales and average inventory can be found on the company’s income statement and balance sheet.
A low inventory to sales ratio means that the sales are high and inventory is low, which indicates excellent performance for the business. In other words, a low inventory to sales ratio means that the business can quickly clear its inventories by way of sales. This shows efficiency in the operation of the company hence leading to high chances of making a profit.
A high inventory to sales ratio means that the rate at which the company is witnessing a significant increase in inventory compared to the speed of sales. This can as well be interpreted that the goods stocked were not aligned to customers’ taste and preference leading to dwindling sales for the firm. When the inventory is high, the firm might be a force to incur storage and maintenance cost, which reduces the profit margin of the organization.
Inventory to Sales Ratio Example
ABC Company Limited is a small dealer in foods and beverages, based in Pakistan. The company reported sales of $8,500 in gross in 2017. The company had $1,700 and $300 in beginning and closing inventories respectively. Two different customers returned goods worth $500.
In the fiscal year 2018, ABC Company Limited reported sales worth $4,250 and customers return of goods worth $250. The beginning and closing inventories were $300 and $500 respectively.
By using the provided formulas, you can calculate this company’s inventory to net sales ratio for each year as follows:
2017
We can use our understanding of average inventory and net sales to find these values with the information provided. For the average inventory, we’ll add the beginning inventory ($1,700) and the ending inventory ($300). Then we’ll divide them by two.
For net sales, we’ll subtract the returns ($500) from the gross sales ($8,500)
- Average inventory = $1,000
- Net sales = $8,000
Now that we have everything, we can calculate our ratio using the formula:
$$\text{Inventory to Sales} = \dfrac{1{,}000}{8{,}000} = 0.125$$
2018
- Average Inventory = $400
- Net sales = $4,000
Finally, we can calculate our second inventory to sales ratio:
$$\text{Inventory to Sales} = \dfrac{400}{4{,}000} = 0.1$$
As always with ratio analysis, comparisons should be made against similar companies or companies operating in related industries. This ratio can also be used to compare the current and past performance of a company to see if there is any trend line of improvement or not. For instance, in the example above, ABC Company Limited, in 2017, that ratio was 0.125, and in 2018 the ratio is 0.1 showing a positive trend in its operation.
This can be interpreted that in 2018 the company was quickly clearing its inventory by way of sales compared to 2017 which could further be said that the company is employing strategies such as sales promotions or giving discounts to liquidate the stock faster.
Inventory to Sales Ratio Analysis
Calculation of inventory to sales ratio is not always as simple and straightforward as it looks in the formula because the key variables are not found directly on a typical financial statement. Sales in many companies are seasonal, and therefore this fluctuation justifies needing the average of inventories across the whole year.
This ratio is crucial for making intelligent inventory management decisions in a company. It is more useful when tracked on a trend line for a period of 3 to 5 years. Inventory to sales ratio for only one year alone cannot be used to determine when there is improvement or regression in the company’s performance.
It is therefore advisable that before you arrive at your final judgment on the company’s performance, look at multi-year figures to ascertain if there is any improvement.
Both high and low inventory to sales ratio might have different interpretations based on situations present. Some companies might have a culture of always maintaining higher inventories regardless of what the sale; hence they will always have a relatively higher ratio. Similarly, low ratio can be as a result of both sales and inventories coming down considerably, but the ratio remains the same.
Thus, it is essential that analysts use this ratio to keenly look at inventory and sales individually to ensure that the company is moving in the right direction.
Inventory to Sales Ratio Conclusion
- Inventory to sales ratio measures the rate at which the company is liquidating its stocks
- It is an analytical tool used to gauge the operational efficiency of a business.
- This formula requires two variables: net sales and average inventory.
- High or rising inventory to sales ratio indicates that the company is incurring more storage and holding cost.
- Low or reducing inventory to sales ratio suggests that the business is in good health and is efficiently operating.
Inventory to Sales Ratio Calculator
You can use the inventory to sales ratio calculator below to quickly calculate the rate at which businesses are liquidating their stocks by entering the required numbers.