This is a thorough guide on how to calculate Inventory to Sales Ratio with detailed analysis, interpretation, and example. You will learn how to use its formula to evaluate an organization's efficiency.
Definition - What is Inventory to Sales Ratio?
The inventory to sales ratio measures how efficient a company is in managing its inventory.
This ratio establishes a relationship between a company’s sales and its inventory.
Inventory management is always a difficult task. You always want to have sufficient inventory to cater to the demand in the market.
At the same time, if the inventory starts to build up, the costs to store and manage it will eat into the firm’s profits.
To be efficiently operational, a business has to maintain its inventory in such a way that it never has either too much or too little of it in stock.
In order to calculate the inventory to sales ratio of a company, you can use the following formula:
Inventory to Sales Ratio = Average Inventory / Net Sales
To calculate this ratio, we simply divide the inventory by the total net sales.
Net sales is calculated by subtracting any sales returns from the company’s gross sales, like so:
Net sales = Gross sales – Returns
We use the average inventory as it takes out any seasonality effects while calculating the ratio.
Average Inventory is the average of beginning inventory and ending inventory.
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
You can easily find the inventory figures on the company’s balance sheet, and the sales revenue on its income statement.
Now that you know all the formulas for calculating this ratio, let’s consider a quick example.
Company A has $1,000 in gross sales. But one of its major customers returns $200 worth of goods during the period. The beginning inventory was $80, and the ending inventory was $100.
By using the provided formulas, you can calculate this company’s inventory to net sales ratio, as follows:
As you can see that Company A has an inventory to net sales ratio of 0.11.
However, this value alone tells us nothing about how this company is doing with its sales and inventory.
You should keep in mind that this ratio is more useful when tracked on a trend line.
That’s to say, you must examine the inventory to sales ratios of a company over the past 3 to 5 years.
When you look at multi-year figures, you can easily determine if there's any improvement or regression.
Interpretation & Analysis
A company can use this ratio to make critical inventory management decisions.
In general, a low value of this ratio is good for business. A low value might suggest that sales are high and inventory levels are low.
It means that the business can quickly get rid of its inventory by way of sales and thus represents efficient operations.
A high value of this ratio could mean two things. Either the firm is witnessing a major increase in its inventory or the firm's sales are dwindling for some reason.
A company can also use this ratio to see any trend changes by comparing the historical values with the current value.
The ideal range for this ratio will depend on the industry in which the firm is operating.
As some industries have a higher inventory requirement, they will have a relatively higher value of this ratio.
We can use this ratio for comparison with similar firms or with companies operating in similar industries.
Cautions & Further Explanation
We have to be careful while analyzing this ratio. As we have seen above, a high or a low value has many different interpretations.
A low value may signify that the firm is quick in converting its inventory into sales.
But it is not necessary. It may also be the case that both the inventory and sales are coming down drastically but the ratio stays the same.
Thus it is imperative that you look at inventory and sales individually to ensure that the company is moving in the right direction.
Similarly, a sudden spike in its value may either mean a very high inventory buildup or a sudden dip in sales.
Both these causes have the same impact on the ratio, but both problems have very different solutions.
You need to keep these aspects in mind while evaluating this ratio.