Key metrics or the lack of them are a pet peeve of mine when it comes to small business owners. It seems 50/50 whether the business owner reviews key metrics or the accounting staff thinks to provide them. This week my first year accounting class began to learn about certain key ratios or metrics. I thought specific key metrics make for good blog topics from time to time.
Let’s start with inventory turnover. The formula for calculating this ratio is:
Cost of Goods Sold/Average Inventory
The purpose of the ratio is to measure how many times inventory turns over. The higher the ratio the faster the turnover which would indicate you are selling your goods and not accumulating obsolete inventory.
Why should you care? Here are a few reasons:
- Slow moving inventory ties up cash and can drive up your cost of capital (i.e. interest expense). If cash is tied-up you might need to use your line of credit to make payroll and pay your vendors. If you’re fully extended on your line of credit or don’t have one, what now?
- Slow moving inventory raises storage costs.
- A lower ratio can raise the question of how efficient you are in managing your inventory.
- A lower ratio can suggest demand for your product has dropped.
How often should you calculate the ratio? No less than monthly even in the best economy. Inventory turnover and other ratios are early warning signs that something is not right in operations. Failure to review this ratio on a timely basis could mean you’re not around by year-end.