In this article, we explain what inventory to sales ratio means and why it’s a vital metric for your business. We will also walk you through our real-world example on how to calculate it. Read on to learn more.
The inventory to sales ratio represents the proportion of your inventory in relation to your sales. A higher ratio suggests the firm holds more inventory compared to its sales, indicating potential overstocking, while a lower ratio may suggest efficient stock turnover or potential understocking.
Example: For instance, if Apple Inc. has inventory worth $5 million and sales of $25 million for a given month, its inventory to sales ratio would be 0.2 or 20%. This ratio indicates that for every dollar of sales, Apple holds 20 cents worth of inventory, suggesting efficient stock management relative to sales volume.
The inventory to sales ratio is important as it indicates the efficiency of your inventory management. We list some key reasons why below:
Stock Turnover Efficiency: A higher ratio can indicate slow-moving stock or overstocking, which ties up capital and increases holding costs.
Inventory Aging: A consistently high ratio might suggest obsolete or outdated inventory which can lead to write-downs.
Liquidity Concerns: Holding excessive inventory can strain a company's liquidity, potentially leading to financial challenges.
Understocking Issues: A very low ratio might mean missed sales opportunities due to stockouts, impacting revenue.
Operational Efficiency: This metric can be used to gauge the effectiveness of procurement, production, and sales processes.
Customer Satisfaction: Proper inventory levels ensure timely product availability, leading to better customer service.
To calculate the inventory to sales ratio, you will need the inventory value and sales value for a specific period. The formula is:
Inventory to Sales Ratio = Inventory Value / Sales Value
Where:
Inventory value = The total monetary value of the goods that a company has in stock at a specific time, not yet sold or used.
Sales value = The total revenue (or monetary value) from goods sold or services provided during a specific time period.
By calculating the value of your inventory as a percentage of sales, businesses can determine the relationship between their stock levels and sales.
Let’s consider Tech Ridge Solutions, a tech company, as an example. To assess their inventory management for the previous quarter, they decided to compute their inventory to sales ratio:
Given:
Inventory Value = $10 million
Sales Value = $40 million
Using the formula:
Inventory to Sales Ratio = Inventory Value / Sales Value
Inventory to Sales Ratio = $10 million / $40 million
Inventory to Sales Ratio = 0.25 or 25%
A moderate ratio like 25% suggests that the company strikes a balance between having sufficient stock to meet demands without overstocking. Overstocking can tie up capital and increase holding costs, while understocking might lead to missed sales opportunities.
We hope this article has given you a better understanding of the inventory to sales ratio and how to calculate it.
If you enjoyed this article, you might also like our article on inventory turnover ratio formula.
