Is Your Inventory Silently Draining Your Cash? Decoding Your Inventory Turnover Ratio
(Listen on Apple or Spotify. Full transcript below.)
Picture this: a meat business with amazing sales numbers, growing very quickly in terms of revenue, and seemingly everything going right.
Yet somehow, their cash flow was terrible. The numbers didn't add up until we dug deeper and discovered the culprit—eight months of chicken inventory sitting in expensive freezer storage, essentially hemorrhaging cash while collecting rent.
This disconnect between strong sales performance and poor cash flow is more common than you might think among food entrepreneurs. One key to understanding what's happening? Your inventory turnover ratio, the metric that reveals whether your products are converting to cash or quietly draining your resources.
What Your Inventory Turnover Ratio Actually Tells You
Your inventory turnover ratio shows how many times your company purchased inventory and then sold through it in a given timeframe. Think of it as asking: "How efficiently am I converting my inventory investment into cash?"
But here's where most founders get stuck—the ratio itself is meaningless without context. A result like "2.75" tells you nothing actionable. The magic happens when you transform that number into days.
From Confusing Numbers to Clear Insights
Here's where the magic happens: transforming meaningless ratios into actionable intelligence.
Take a food company with $990,000 in annual cost of goods sold and $360,000 in average inventory value. Using the inventory turnover calculation, they get a ratio of 2.75. What does that mean? Nothing helpful on its own.
But convert that ratio to days, and suddenly everything becomes clear: it takes this company 146 days—nearly five months—to sell through their inventory. Now you have information you can actually use to make decisions about cash flow, ordering, and storage costs.
This transformation from abstract ratio to concrete timeframe is what makes inventory turnover analysis so powerful for food entrepreneurs.
Cash-Based Businesses: A Different Formula
If you're using cash-based accounting, you'll need a modified approach since your P&L shows all inventory purchases, not just what you've sold. Instead, use your revenue number divided by your average inventory value (which requires physical inventory counts since you won't have inventory assets on your balance sheet).
This inventory-to-sales ratio works inversely—lower numbers indicate more efficient inventory management. A result of 0.18 means you have 18 cents of inventory for every dollar in sales.
Why Industry Benchmarks Miss the Point
Every food business is unique, and that's especially true for inventory management. A 146-day turnover might be perfect for one company and disastrous for another. Here's what actually matters for YOUR business:
Lead times: If it takes two months to get new product, having extra inventory isn't necessarily bad. But if you can restock quickly, five months of inventory might be tying up unnecessary cash.
Growth plans: About to double sales through new distribution? You'll need more inventory on hand to support that growth.
Product shelf life: Six-month shelf life with nearly five months of inventory? That's cutting it dangerously close.
Cash runway: Tight on cash? Consider whether reducing inventory could free up capital for marketing or other growth initiatives.
Storage costs: Like our chicken inventory example, don't forget the ongoing cost of storing products, especially refrigerated or frozen items.
Making This Work for Your Business
Calculate your current inventory turnover ratio using the timeframe that makes sense for your business. If you're cash-based, start with physical inventory counts at consistent intervals.
Most importantly, view this ratio as a diagnostic tool rather than a report card. If your cash flow doesn't match your sales performance, inventory might be the culprit. Use this metric to ask better questions: Which products are moving slowly? Are my order quantities appropriate for my current sales velocity? Am I paying storage costs for inventory that could be better utilized as working capital?
The inventory turnover ratio won't solve your cash flow challenges overnight, but it will give you the visibility needed to make smarter inventory decisions. And for food entrepreneurs building sustainable businesses, that clarity can be the difference between thriving and merely surviving.
Ready to dive deeper into inventory turnover calculations? Watch to the complete episode where I answer listener questions and walk through real examples of how this metric reveals hidden cash flow issues.
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Episode Timeline
00:00 Introduction and Listener Engagement
02:30 Understanding Inventory Turnover Ratio
06:08 Calculating Inventory Turnover Ratio
09:14 Interpreting Inventory Turnover Ratio
17:33 Contextualizing Inventory Turnover for Business
24:09 Cash-Based vs. Accrual-Based Accounting
29:21 Inventory Management Strategies
37:06 Conclusion and Key Takeaways
Full Episode Transcript
You listening to the Good Food CFO Podcast. I am your host Sara Delevan and with us as always is our producer Chelsea Stier. Hey Chelsea!
Hey, Sarah, we are, or you, I really should say, are answering another listener question today.
Yeah, this episode actually comes as a result of two people asking questions around the same topic. So we decided to devote an entire episode to answering their questions.
Yeah, but Sarah, before we get into that, we have a new BABOYOT member to shout out here on the podcast. Our new BABOYOT member is Amber Stevenson of Rosebuds Real Food. Rosebuds makes organic seasoning mixes and gluten-free baking mixes to make your meal time simple, nutritious, and delicious. And they have been in business for almost 12 years now. She says that they are still growing, evolving, and working hard.
to streamline their processes and understand their numbers. I think that's part of why they decided to become a Bobby Op member, but they have been working to increase their wholesale and they're also being asked to act as a co-packer. So I thought that was really cool. If you want to learn more about Rosebud's real food, you can visit www.rosebudserielfood.com.
We'll of course put that link in the show notes as well. I want to say a big public thank you to you Amber and to Rosebuds. I'm looking forward to meeting you at one of our upcoming BABOYOT events. Thank you so much for being a part of our community.
Yeah. Okay. So as we mentioned at the beginning of the episode, we are answering some questions around actually a recent episode that we did last season. episode was where you were breaking down like the five reports or like essential reports that you think every founder should be kind of checking in with and the order in which to do so, right? To add them into your routine.
And at the end of the episode, you were talking about the balance sheet. And when we talked about the balance sheet, you mentioned inventory turnover ratio. And I think in the episode itself, you might've given a pretty short, like, this is how you get your inventory turnover ratio, but we didn't spend a lot of time on it. And then shortly after that episode aired, we heard from multiple people who were like, how do I find my inventory turnover ratio?
Yep.
Yeah, and like what does it tell us about our business? And I thought it was really interesting. And to be honest, I was like, they're listening to the entire episode and they've made it to that last report on the list and they have questions. I was very excited about that because to be honest, they're all important, right? We were, as you said, of ranking order of importance for which founders should be paying attention to certain reports. And so was exciting.
to get questions on such a small part of the episode and this very specific ratio that we were talking about. It is a valuable ratio for many brands and I was excited to dig into answering their questions.
Yeah. And I think that, you know, I felt like you did a very good job of, and as people will hear in the episode, really separating like who should be looking at inventory turnover ratio, who should be looking at something else, how do you differentiate, and then what those numbers actually tell you about your business.
Yeah, when you look at a ratio, like a financial ratio, we don't talk about them a lot here, they're kind of weird to interpret, right? Like you're getting answers like 3.2, you're like, okay, well, what do I do with that? So we talk through like, what do you do with that? How do you convert it into a metric that has like some actual meaning? And then what do you do with that metric and how do you assess what...
it means for your business because Chelsea, as we say so, so often, every business is unique. So if one company gets a 3.2 and another company gets a 3.2, it's not inherently good or bad and it's going to mean different things for each of those businesses based on some specifics. So we also dive into how to interpret that ratio, how to utilize it, and whether or not, as you kind of hinted at, you need to be.
looking at this number as well.
Yeah, definitely. Well, Sarah, think we're gonna take a short break here, but then I'm ready to dive in.
Yeah, let's do it.
and receive a 10 % discount on all of our tools and services when you choose an annual plan. Join fellow successful founders at thegoodfoodcfo.com slash BABOYOT. That's spelled B-A-B-O-Y-O-T. Together, we're changing the way that food business is done. Now, back to the show.
So Sarah, we are back again with another listener question episode today, as I mentioned in the intro. And this episode is really about like one question that was asked a couple of different ways. So I'm going to just quickly cover the two questions that we got for this episode. And then I cannot wait to jump right in.
person that wrote in about this particular topic was our very good friend Danielle. She said very succinctly, how do you calculate inventory turnover ratio at the Good Food CFO? Then we had another question. This was actually a comment on Spotify. It was exciting to see comments starting to come in on Spotify. This one is from Trisha. She said, can you further explain what inventory turnover
is at a very high level? Like what does turnover mean? Are you referencing the total amount of inventory that's sitting on your shelf at the end of the year? I know that you said average, but in what time period are you looking at to find that average?
Yeah, really good questions.
Yeah, so I am excited to hear what I'm sure will be your very thoughtful answer and then to continue to ask you more questions when I don't understand. So let's jump into it.
Okay, so I'm going to start with the timeframe element here. So you can calculate your inventory turnover ratio for any timeframe that you choose, but typically it's done for one year, but you could also look at it, for example, for a six-month timeframe. So let's say we're going to look at our inventory turnover ratio for one year. When we talk about the average, what we're
like the average inventory, which is part of the formula, we're looking at essentially the starting inventory for that year. So that is number of units on shelf at the beginning of the year. And then we're going to also look at the number of units on shelf at the end of the year. We're going to add those two numbers together and divide by two to get an average inventory value. Okay. Okay.
If you were doing that for a six-month timeframe, you would simply have your inventory on hand at the start of the six-month timeframe that you're looking at. Let's just say it's January through the end of June. Is that six months? You would have the starting inventory as of January 1 and the quote, unquote, ending inventory as of the end of June. You would add those two numbers together and divide by two. The reason that this is done is to primarily smooth out any
seasonality or anything, especially if you're doing it in a timeframe that's not one full year. So if you're doing it for six months and you have a peak season within that six month timeframe, taking the averages is a good thing to do.
Yeah, that was going to be my question is if you are a seasonal business and you were looking at it, like would you want to look at it more closely than over an entire year if you do have times of the year where maybe you have way more inventory on hand because of the seasonality of your business versus maybe other times of the year where, you know, your sales just are not as high and you don't have, or maybe you do have more inventory because your sales are not that high.
Right. Yeah, think depending on… As we move through this episode and we kind of dig into the answers to the questions that were posed, what my hope is is that you'll identify how often you should be looking at your inventory turnover ratio. If it's, let's say, a metric that you need to quote unquote improve on, you might want to look at it at a six-month timeframe rather than waiting for a full year. Got it.
can be helpful to you to go, am I on the right track? You're not going to make a lot of moves in a month or possibly even three months when it comes to like moving inventory, but six months you can potentially have an impact and over the course of a year if you need to make changes or like I said, improvements if you will, you should start seeing them over that year. Okay. So the next question like around like what does turnover mean, right? Turnover…
is essentially another word for sold through. Inventory turnover ratio shows us how many times your company purchased inventory and then sold through it in a given timeframe. Today, we're going to use a year primarily. Instead of saying inventory turnover ratio, you might say, let's calculate how many times we sold through our inventory this year. It's the same thing. That makes sense, Yeah. Okay. Then the ratio
that you calculate, and this is really important, for your business is going to be relative. This is another way of me saying it depends. Because you could calculate your inventory turnover ratio and benchmark it against someone else in the industry or an entire segment of the industry. But I'm going to recommend that as an emerging good food brand, you track it over time for your business to understand what it means for you.
and your cash flow and your cash management, your overall strategy. We're going to dive into that a bit more later, but I don't really want you to be comparing this to an industry benchmark.
Yeah. No, I completely understand what you're saying. And I think that that's a really good call out, especially for emerging brands to really start to gather their own data about what's going on in their business. I love that.
Yeah. Here's another actually extremely important thing we need to talk about before we go further into these calculations. And that is that the inventory turnover ratio, that formula specifically is intended for brands that are using accrual-based accounting. If you're using cash-based accounting, which I know many like new and sort of like we'll use that word emerging brands,
are using, there's a different formula for you. So hang through. Stay with us if you're a cash-based accounting company because I still think there are things you can learn from the conversation. But then I'm going to give you the formula that you should use as a cash-based business to learn something about essentially your inventory turnover ratio. Yeah.
Kind of diving into that more, the reason I'm making that distinction is because the inventory turnover ratio requires a cost of goods sold number that is the actual cost of goods that a business has sold. And that number will be found on the P &L for companies using accrual-based accounting. For a cash-based business, you're going to see all of the cost of goods sold and the cost of your inventory
on the P &L, right? Because it's based on essentially when you spend, let's say, $25,000 to purchase new inventory, it all is going on to your P &L as a cash-based business. 25K spent in the month of March, As opposed to an accrual-based business that is potentially still spending that $25,000, but that's all going to go into an inventory asset account on the balance sheet. sheet. And then as the product is sold,
the cost of sold is going to move over to the P &L.
Okay, that makes sense. Yeah. And it also makes sense as to how this whole conversation started in the first place, talking about the balance sheet.
Exactly.
So I'm in a cruel based business. have my fresh P &L from the month of May printed out, ready to go. I'm looking at those cogs, those like actual costs of what was sold. How do I take that number? Like what's the formula here to start to look at that inventory turnover?
Yeah. So we're going to walk through this in three steps. We're going to talk through the first two steps and then we're going to take that outcome and walk through the third step essentially. Right. So the first thing we're going to do is calculate that average inventory value that we talked about a couple of minutes ago. So if you are at the end of May and you're doing a six month, I'm going to say a year, right, because we're just going to stick with that year timeframe, you're going to go to 12 months prior and you're going to look at what was my inventory value at that point.
Right? So that you will find on your balance sheet. So go to your balance sheet and pull that inventory value. And then you're going to look at your balance sheet for the end of May and pull that inventory asset value. And you're going to add those two numbers together and divide by two. Now you've got your average inventory value. So that's step one. Okay. The next thing you're going to do is calculate the inventory turnover ratio. And so that's going to be the cost of goods sold for that same timeframe.
divided by that average inventory value that you just calculated. So you're going to run your P &L for the full year, right? So it's going to be essentially June 1st of the prior year through the end of May of the current year to give you a full 12-month P &L. And you're going to take that total cost of goods sold for that period and divide it by the average inventory value. We've got some numbers. So if you're someone who likes to kind of jot things down,
you know, to sort of take it in, maybe grab a pencil or something and jot this down. So the sample company we're using today has cost of goods sold for the period of $990,000 and their inventory value for that timeframe, the average inventory value is $360,000. Okay. So when we do that math, the ratio we get is 2.75.
To be quite honest, that number doesn't mean much. Let's go to that final third step, which is going to put this number into some context for us. We're looking at a one-year period, which is 365 days. We're going to take 365, divide by 275, and the answer we get there is 146. This is where we get helpful information. 146 is the number of days it takes this company to sell through their inventory.
Right? If we take 146 and we divide by, let's just say, 30 to get like a rough monthly average, another way to look at this is to say it takes 4.86 months to sell through inventory. Okay? So let's just walk through this one more time. So we have our product COGS for the timeframe, $990,000. We have our average inventory value, which is $360,000. Okay?
We take those cogs, we divide it by the average inventory value, we get the number 2.75. Because we're looking at a full year, we're going to then take 365 and divide by 2.75 and our result is 146. 146 is essentially the number of days it takes for us or this company to sell through an inventory purchase or sell through its inventory.
If we take that 146 and we divide by 30, we get 4.86 and that's roughly the number of months it takes to sell through inventory.
Okay, so I just want to run through very quickly one more time where we got all this information. So those product cogs, you said we're pulling from our P &L. So we're pulling a P &L for a full 12 months. That's where we're getting that number. Yep. Then the average inventory value, that was from the two inventory values that we pulled from our balance sheet. Correct. And that's where we got that number. That turned into the, when we did the math, 2.75 for our inventory turnover ratio.
And then the 365 that we're dividing, that just comes from the calendar because we're looking at a whole year. And then that's where you got the 146 when you did that math. And then dividing by the 30 days, as you said in the month, put us at 4.86.
Yes. So for context, if you're going to do this for a six-month timeframe, you won't use 365, right? You'll figure out how many days are in six months, right, in an average six months. And then that's the number you would use in place of the 365, right? So you're going to adjust it a little bit based on the timeframe that you're using. And so this is a number, this 146 days or these 4.86 months, this is a number that is telling us a story, right?
But I'm sure Chelsea, you can hear our audience in the distance saying, what does it mean? Is that good or is it bad? Yeah. And the answer of course to that is, yeah, it depends. It depends. But let me give you some context that will help the it depends make a little bit more sense. So generally speaking, the higher the inventory turnover ratio, the faster you're selling through and quote, turning over your inventory.
Right? Because let's say, for example, the ratio was like instead of 2.75. We'd be dividing 365 by 5, the result would be smaller than 146. And so the timeframe in which we're selling through our inventory would be shorter. the lower the number, the slower you are turning over your inventory. Right? And again, whether that is good or bad depends on
the specifics of your business. I think one of the most important things to think about here is what is the lead time for you to get new product? If it takes two months from the time you place an order to the time that you receive your order, having an extra two months of inventory on hand or having 2X the inventory that you need on hand is not a bad thing, right?
If you are making your own inventory in-house and you've got four months of it lined up, but there's not a long lag time for you to get your ingredients or for you to get your packaging, then 4.86 months might be a bit too long for your specific business, right? You also want to think about what your expected growth is. If you're running
like over the last year, 4.86 months of inventory on hand. But you're about to double your sales because you're launching into a new channel or you're moving into regional distribution or something like that, right? That inventory turnover rate is about to drop and you need to have a decent amount of inventory on hand to support that growth, right?
The other thing you might want to think about is how perishable are your goods? If you've got a six month shelf life and stuff is sitting on yourselves for four months, almost five, this is not a good ratio for you specifically. And then I'd say the last thing you want to think about, at least for the sake of this episode, is your cash runway. If you have a short lead time to get your ingredients and your packaging right and to get new product on your shelf,
and you've got nearly five months worth of inventory as your inventory turnover ratio, but your cash flow is a little tight or you could use some extra cash to execute maybe a marketing strategy or something. Maybe you want to adjust and get your turnover ratio down to like 3.5.
Yeah. Right. Or even three or something less, right? Because then that puts more cash in your bank account and less cash tied up in inventory.
Yeah, and I feel like I always point this out when we talk about inventory too, is like, where are you storing that inventory and is that costing you any?
Yeah. Yeah. I think too, something else we should talk about is like, when you do this ratio, it's looking at all of your inventory, right? If you have more than one product or if you have multiple SKUs, there is something to be said about looking into which products are sitting in inventory the longest, right? Is there a particular product that is
influencing that ratio or the number of days in inventory? Or is this like all of your products that are sort of moving at the same rate? I know that I've talked, this was a while ago now, but about a meat business where we realized that they had a lot of chicken in stock. They were moving very quickly through their primary products, which was like beef, but analyzing their inventory,
revealed that they were sitting on months worth of chicken inventory. They had eight plus months of inventory in the freezer with a scheduled repurchase coming up. It was like, no, no, we're going to cancel that order and we're going to run some promos on chicken because they were paying, as you just pointed out, for storage. They had to keep that chicken in the freezer, so they're paying rent essentially. They had not only
were had an increased rent expense for the amount of chicken that they were storing, but they also had a lot of cash tied up in that chicken inventory. Yeah. Right? So that's like, and the sales numbers were amazing. They were growing very quickly in terms of revenue. And so like you wouldn't necessarily think, I wonder if there's an inventory issue here. I wonder what our inventory turnover ratio is.
we decided to look into it as the finance team because the cash flow wasn't flowing the way that it should have based on the revenue, based on how that beef inventory was moving. was like something is up. And so in that instance where you're like, what is going on? We ran a number of ratios and that's where we found out something's going on with inventory. What exactly is it? In this specific case, they also happen to have a lot of bones.
in inventory. So we found a couple of things, but then it became a strategy for let's get rid of this stuff because it's actually going to save us money.
I actually love this conversation because I love that you're pointing out that here was a business who's showing really strong growth, high revenue, everything on paper looks like it should be going good, but then there was a disconnect when it came to their cash. so having this in your back pocket of, hang on, let me go and check my inventory ratio.
Like just having that extra layer of digging in and understanding what's really happening in your business.
Yeah. And I think, you know, this is also a good point to bring up. I talked through what reports to pay attention to, right? And I gave an order, right? And cashflow was at the tippy top of that list. And if you're monitoring your cashflow, you're projecting your cashflow, and you don't understand why your cashflow doesn't look how you think it should, digging into the other reports can be beneficial.
Yeah. To you, right? We use the profit assessment a lot to look at the business holistically and say, what could it be that is creating this financial outcome beyond the P &L, right, in our business? And oftentimes, I think we've talked about it before here, Chelsea, we've got that decision tree, right? Yeah. There's a point on that decision tree where it says, okay, if your margins on your products are good, right, but you've still got
like something funny happening, go check your inventory. Go see how long you're holding onto inventory for. There are businesses, especially emerging brands, people who are just launching, people who are working toward that first million dollars in revenue, they have gigantic orders. They've got, if you're working with a co-packer in particular, right, you've got
big orders because there might be an MOQ, meaning minimum order quantity that you are locked into. You might have to purchase big quantities of packaging in order to be able to place the order or in order to save a couple of cents per unit. We've sort of been talking about finished goods essentially, but let's just talk about another type of inventory, which is simply packaging inventory. You might have empty
bags, empty boxes, empty tins, empty jars, whatever your packaging is, sitting on your shelf in the warehouse. You might have a year's worth of that packaging inventory. You might have two years' worth of that. That is going to impact that turnover ratio. That is absolutely going to have an impact on your cash flow because essentially every unit that's sitting in your inventory
that is not selling or not sellable like within the next 30 days, that's like pictured as dollar signs. tied. Sitting. Can't do anything with that until I sell it. So the shorter amount of time it lives on your shelf, the quicker you can turn it into cash and into hopefully a gross profit margin above 50 % when you sell that product. So it's very beneficial to sell goods, right? And it's less beneficial to have whether it's finished product.
up money.
ingredient inventory, packaging inventory sitting on your shelf for too long. Again, you got to take into account how long does it take me to get this packaging? How long does it take me to get my finished product? What is a amount of time or safe amount of inventory to have so that I don't run out because we don't want that to happen either, right? But so that I'm not sitting on this for an extended period of time and tying up my cash.
Yeah, seems like it's, again, right, it depends. It's nuanced. It's very much based on your business and the levers within your business, right? But I think that it's such a good call out to look at it and really understand like what does my lead time need to be? How much inventory do I really need to have on hand? And when you can dig in and answer those questions for yourself,
then the information that you can get from calculating your inventory turnover becomes that much more useful.
Earlier in the episode today, we talked about your ratio not necessarily needing to be compared to someone else in the industry or to an industry standard, but to be compared just over time within your business. Let's say that you start out with a five-month number. It's taking you five months to sell through your inventory and you determine that that's longer than it needs to be for you.
Then you can start to take whatever the steps look like to reduce that inventory, reduce the amount of units, I guess I should say, you have in your inventory, modify your ordering habits, your ordering timeframes, et cetera, and then check back in, in six months and you might not see a huge change, but then again, over a year, and you want to start seeing a change. You want to start seeing that…
2.75 going up, eking up to 3.25. You want to see that changing. It's not that you necessarily want to see the inventory value in terms of dollars going down because if your sales are going up, if your revenue is increasing, you're selling more product, you might actually have a higher inventory value in terms of dollars. That's why we're looking at the ratio. You want the ratio to go up?
you don't necessarily want the inventory value in dollars to go down. Yeah. Make sense? Yeah.
That's a very good call out. So, okay. I'm really understanding now the value of this ratio and why we would want to look into this, but I want to get back to something you said earlier, which was you were talking about cash-based businesses and how things differ for cash-based businesses. And I'm very curious how you would use something like an inventory turnover ratio in that sense because...
Mm-hmm.
the way that you're collecting the data in that business is going to be so different.
Yeah. Number one, and let's just kind of go over this again, the cost of goods sold that is showing on your P &L is really going to encompass every penny you've spent for product, packaging, et cetera, even if it's still sitting on the shelf, technically as inventory, right? So we can't use the COGS number. So in place of the COGS number, we're going to actually use a revenue number. Okay. Additionally, though, because you're not
an accrual-based business, you're not going to have an inventory asset account on your balance sheet. That doesn't exist for cash-based businesses. So for you to gather your average inventory value, you will have had to do a physical inventory count. Now, accrual-based businesses also should be doing physical inventory counts at least once a year, but this is going to be a requirement to have a number.
to work with. As a reminder, when we have inventory, it is valued at the cost of that inventory. Meaning, let's say your finished product cost you $5 but you sell it for 12, the value of that inventory is $5. It's not $12. Okay? I got you. You're going to want to do a physical count of your inventory at that start point and then whatever the end point is for the timeframe you're looking at, you want to do an inventory count there as well.
determine the value, the cost value of that inventory and sort out the average. Same way, right? Beginning plus ending divided by two. Okay. And then again, you're going to take your sales number instead of your cost of goods sold number. Okay. And then the formula in this case is going to be your average inventory value divided by sales. Okay.
Okay, so that's gonna look a little different.
It's quite literally the inverse, right? The formula is the inverse. And the number that the ratio is going to spit out is going to look very different. So what I did to try to have some continuity here was I took the original set of numbers that we are working with and I made an assumption that this company has a 50 % product margin. So from that $990,000 of cost of goods sold, they would generate 1 million.
$980,000 in revenue. And then we kept that same $360,000 in average inventory value. Okay. So when we were using the inventory turnover ratio, we got 2.75. And when we're using this new inventory to sales ratio, as it is called, our output is 0.18.
So as you can see, those numbers are very different. Yeah.
When using this ratio, a higher inventory to sales ratio suggests that your company might be holding on to excess inventory relative to its sales volume, meaning you're not turning over your inventory very efficiently. And the lower the inventory to sales ratio implies that the company has a lean inventory management style and perhaps a tighter control over their inventory levels.
Period. Right?
Okay, so this is, we're basically talking about the opposite, our inventory turnover ratio.
Exactly. Of our… Exactly. So going back to the numbers we have here, the inventory to sales ratio that we have calculated is 0.18. And now one way that this could be viewed is that for every dollar in sales that you generate, you have basically 18 cents of inventory. Okay?
Again, this could be like, that a good thing or a bad thing? It's a little bit more clear here than it is in the inventory turnover ratio. Let's start with if the result of this formula was a one, right? That would mean that for every dollar in sales that you have, you have a dollar worth of inventory value, worth of inventory on hand.
And I'm thinking that that inventory value on hand is the cost, not the sales price. having those equal doesn't seem.
Yeah. We can't say that it is the cost, but it's a good way to frame it in your mind. Okay. Okay. If the output of this inventory to sales ratio was, for example, 1.25, that would mean that for every dollar in revenue that you are generating, you actually have $1.25 in inventory on hand. That's not great. That means that we've got a lot more inventory on hand than what we're able to
sell, let's say, in this year. Basically, we want this number to be as low as possible, as far away from 1 as possible to a certain extent. For your business, 0.18 might be perfect. Again, we're using essentially the same numbers as we did in the first example. 0.18 might – When you first do it, you might be like, I don't know.
what this number means for me. But if you then take into consideration that your cash is tight or you're also monitoring how long it takes you to move through a certain lot of product or something like that, you can discern then, hmm, 0.18 might be too high for me. Maybe I could get away with a slightly lower inventory to sales ratio. And so you might make some adjustments.
I personally think that this number is a little bit harder to work with than the inventory turnover ratio.
Yeah, because I think in the inventory turnover ratio, at the end of it, you're looking at like actual time, which I think gives you a lot more clarity.
Yeah, agreed. for like, I know that Danielle, at least the last time we spoke, she was a cash-based business in terms of how she was doing her bookkeeping. So it felt really important to bring this here to have a formula for a cash-based business and to talk about, what could this mean? But I do think it's harder to interpret because we can't really turn this into days.
Yeah. And I think for this cash-based formula, at least the way I'm looking at it is like the first time that you do it, it's probably not going to mean anything to you, right? And it's really going to be on you to, as you said, do that monitoring over time and then decide really what that target should be or if you need to move in one direction or the other.
So it's going to be a lot more like on the founder.
Yeah, I think if I was consulting for this particular brand, I would say, let's look at our inventory values on a monthly basis. Or maybe I would say, let's do a COGS calculation based on what we're actually selling on a monthly basis. I would want another way to track the physical inventory movement through the company.
To essentially associate this 0.18 to an actual physical thing. Now, if you're listening and you're like, Sarah, if you don't love this ratio, then why are you talking about it? it? Because I think that there's that saying, is the juice worth the squeeze? It might not be worth the squeeze.
to do this particular ratio. The ratio calculation takes two seconds, right? It's the inventory counting that's going to take time. I do like an inventory count. I want to know how product is moving at the end of every month. Does that take a long time? Can it be a pain in the butt? Yes. Can it provide you with valuable information? Yes. Yeah.
I suppose the answer to that question is I think there is value in knowing how your inventory is moving through your company, how it's moving through the business. If you're a cash-based business, that means doing a physical inventory count from time to time, paying attention to and keeping track of like when are you purchasing, how is that affecting your inventory, how quickly are things moving and changing, what are your highest selling products.
That's just having a hand on what is happening in your business. You as a founder can utilize this ratio to communicate to other people, this one and the inventory turnover ratio. But you yourself can be doing other things like physically within the business to have your finger on the pulse of what this is, right? Really ratios are for communicating to other people.
If you're communicating to a potential funder, no matter who that funder is, potential investor, a coach, how your inventory is moving, the quickest way to do it is with a ratio and a conversation about how that ratio is changing over time. But inside your business, you don't necessarily need to be talking about ratios. You're going be talking about how quickly is this product moving.
and what is our schedule for bringing in new product and why, right? It's the strategy behind it. If your potential funder investor coach wants to know those details of why is that ratio changing and is this a good thing or a bad thing, then you can kind of dig into it. I really think that these are for communicating. Again, when I did this math for that protein business, I'm not physically with the inventory. We can't get a physical inventory count of everything because it was spread out over the country.
So the ratio helped us figure out that we needed to dig in further. So it's also helpful, but that's as a non-founder in the business wanting to get a handle on things. you know, again, we don't want to overcomplicate things, right? We need good data. We need to understand how things are moving through our business. These ratios can help. They can help us track changes over time. They can help us to communicate. But if you are not,
calculating these inventories or these these inventory ratios that is totally fine.
Yeah, and I love that we got these questions in the inbox and in our comments because it is very clear that people are interested, that they are looking into this, that they want to understand how to understand, right, to get a better handle on their business. And so that means that
they want to do the work. So I think that's like a number one, a positive thing. I think digging into how to do it is like so great, but I think that your advice here of like, what is it really about? What are you really trying to understand and how are you understanding that in your business is so, so important.
Yeah. I'll add one more thing. think that if you are a founder that has a team, right? I know I work with some founders that have brokers. They might have like a lead salesperson and they are working with them. They're forecasting being onboarded with new retail stores, for example, and then they're also trying to figure out how much inventory do we have and how much product should we produce and what should we buy?
Communicating again across a team, so not just for investors or funding, but communicating across a team, the ratio could be helpful there as well, right, to tell a story and to make sure that the sales team isn't selling too quickly, the brokers aren't onboarding too quickly for what we're able to do with our inventory. Maybe we want to have consistently a three for our inventory turnover ratio. So it might be something that we can monitor and communicate to the team. We need to pull back if our
turnover ratio has gotten really high and we're running the risk of running out of products and we want to service our current accounts. I don't want to imply that it's not valuable at all. I just think that there are certain times and places where the actual calculation of these numbers make sense. Otherwise, the awareness of how is my inventory changing on a hands-on level can often be enough.
So do what is right for you, your team, what you're striving for, and what you want to understand and how you like to think about your business. Then at the end of the day, and we're talking about Bobby Yachts, it's what it's all about. Yeah.
Absolutely. All right. Well, Sarah, thank you for diving into this topic with us. And I want to thank Danielle and Tricia for sending us these questions and giving us the opportunity to dig in. Yeah.
and
Thanks ladies, have a great day.
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