In 2020, we saw the real impact that inventory disruptions can cause to businesses in every single industry.
With the continuing growth of online retail, this impact tends to get worse. And the reason is very simple: everything (sales, marketing, customer service, etc.) is digital, and the only physical aspect of retail is the product. It is only natural that inventory will increasingly become the centerpiece of every retail operation, and managing it efficiently will be a key factor to success.
From a mathematical perspective, when a company has an I/S Ratio of 1.0, it means that during the period analyzed, they had the same capital invested in inventory as their total sales. However, there’s more you need to understand to get the full picture.
There are endless indicators that are used in the world of inventory management, but we will focus on the three most important ones in this article. Evaluated in combination, they can show a lot about your inventory health, but most importantly, their close management can indicate in advance if you are at risk of having problems ahead.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Cost
This is arguably the most used metric in inventory management. Its goal is to measure the number of times your inventory is sold within a period of time, typically one year. For example, an annual Inventory Turnover Ratio of 12 means that you churned your inventory 12 times in a year, or every 30 days on average.
What is the ideal Inventory Turnover Ratio? There’s no one right answer. It depends on your business and your inventory strategy. For companies with complex supply-chains or products with very unpredictable sales, inventory levels tend to be higher to account for unpredictable events, and so the Inventory Turnover Ratio tends to be lower. On the other hand, companies with local supply and stable products can be much more aggressive with their inventory strategy, maintaining a very high Inventory Turnover Ratio.
Overall, businesses want to keep their Inventory Turnover Ratio as high as possible, respecting their sales strategy and supply-chain limitations. A high Inventory Turnover Ratio means more efficient inventory management, which results in less capital deployed to run the business. Another very important reason to keep low inventory levels is that this reduces the risk of keeping obsolete/expired products and improves the speed at which you can respond to customer demands.
I/S Ratio = Average Inventory Value / Net Sales
The I/S Ratio represents the relationship between your inventory value and your total sales. Its objective is to monitor the capital allocated to inventory compared to the company’s sales volume in a given period. The lower the I/S Ratio, the more efficient the company is in allocating capital to its inventory.
While the Inventory Turnover Ratio is very useful to understand how many times you churn your inventory during the period analyzed, the I/S Ratio is used to understand how efficient you are in allocating capital to your inventory. Even though both of these are looking at capital investment, the Inventory Turnover Ratio uses the same base (cost of goods) in both the numerator and denominator, making it a quantity-based index, while the I/S Ratio is a capital-based index.
Overall, businesses want to keep their I/S Ratio as low as possible, respecting their sales strategy and supply-chain limitations. A low I/S Ratio means a more efficient capital allocation, which results in higher profit margins and lower operational risks (if something goes wrong, the potential losses are much lower than if you were carrying a lot of products).
Sell-Through Rate = # of Units Sold / # of Units Received
The inventory Sell-Through Rate represents the percentage of inventory you sold concerning what you purchased from a manufacturer in a given period, usually 30 days. It is used to estimate how quickly you can sell a product, and therefore whether the product is a good fit for your customers. The closer the Sell-Through Rate is to 100%, the quicker that product is selling.
While the Inventory Turnover Ratio and the I/S Ratio measure the efficiency of your whole inventory, the Sell-Through Rate is usually used to measure the individual performance of each product. In other words, it is a portfolio analysis index that helps you quickly identify the top and bottom performers. Products with a low Sell-Through Rate should be treated with more caution, while products with a high Sell-Through Rate should be prioritized.
There are many other inventory management indicators that you can use, but the combination of these three ratios is very powerful. The Inventory Turnover Ratio shows you how many times you are churning your inventory every year, which helps you understand how much you can optimize your supply-chain process. The I/S Ratio shows you how efficient you are in allocating your capital to your inventory, which helps you improve the capital efficiency of your business. And the Sell-Through Rate measures how fast each of your products is selling, which helps you improve your product mix by prioritizing winners. The accurate and close management of these indicators can go a long way toward the success of your online retail business.