The margin of error present for small businesses is very small. The constraint of a tight budget means that even the slightest of discrepancies can leave the planning in tatters. This is why businesses have to use as much protection as they can to achieve profitability. The profitability and performance of a business can be measured and compared through the use of different accounting ratios.
Ratios have been part of the appraisal and planning process for a long time, and through the course of time, every ratio has developed a role of its own. One such ratio which ensures that the inventory management and the cost of holding are in conjunction with the goals of the business is the inventory turnover ratio. This inventory ratio (which is often overlooked in business decisions) holds the capability to turn a small profit into a large one.
The inventory turnover ratio is a method to find out the number of times inventory in the business is sold out during a year. The ratio basically finds out, how efficiently inventory is being managed within the business.
The formula for the ratio comprises of the cost of goods sold, and the average inventory for a given period of time. Cost of goods sold is found by adding up Opening Inventory with Purchases and subtracting closing inventory from the value. Average inventory can be found out by taking an average of both the opening and the closing inventory.
Understanding the Results
The results of the inventory turnover ratio, if carefully studied by an expert, can help the business understand a lot about the handling of inventory within the business. If the ratio is lower than the industry average, it would suggest that the average inventory of the business is high. Meaning that the business is incurring a lot of costs in holding the inventory, like:
The inventory turnover ratio does go a long way in eradicating all minor issues that can affect profitability, but perfection cannot be achieved until a decent tracking system is implemented. A report suggests that 46 percent of the businesses within the United States do not have a proper inventory tracking system implemented. The reasons behind this low rate range from a lack of trust in the system to the sheer negligence of the owners. Owners currently are not aware of the damage that is created due to the lack of a proper inventory management system. A few perks of having an inventory management system installed are:
A proper inventory management system ensures that efficiency within the business increases and that there is a rise in the profit. The presence of an inventory management system, would also cancel out the occurrence of a human error.
You Can Save Time
They say time is money, but as it does not get accounted for in the financial statements, the saying often goes ignored. The time saved through an inventory management system can be used for production activities which can eventually increase revenue, thus cementing the statement that time indeed is money.
Your Return on Investment (ROI) Increases
The return on an investment of a project is an important part of the process of investment appraisal. Inventory management systems, through an increase in profitability, ensure that the return on the investment made is commendable.