You’re in the wholesale or distribution space and have a huge asset, called inventory, which needs to be converted to cash, but you aren’t great at tracking or counting it and you are not really sure which items are sitting. So what do you do? Outlined below are some simple ratios that can give you additional insight into what is happening with your inventory and allow you to start moving in the right direction.
One of the most common ratios that we look at in servicing wholesale and distribution companies is inventory efficiency, or more specifically turnover and days on hand. These ratios provide valuable insight into how successful a business is at managing one of their most significant assets.
In the broadest sense, turnover identifies how many times per year an average inventory clears out of a distribution center and is replenished. That figure is compared against the number of days in a year, and speaks to how many days on hand of inventory you have; meaning if you weren’t going to place another order, how many days it would likely take to sell out of everything.
Generally, the higher the turnover the better, as it would indicate that inventory is efficient and that owners are buying (and then selling) what the market is demanding. A lower than desirable turnover indicates lower sales in relation to carrying higher inventory, which further means cash is tied up in inventory. In some cases, cash is being spent on higher interest costs associated with money borrowed to purchase inventory that isn’t turning over.
While computing inventory turnover and days sales outstanding are a great starting place, you then need to take your ratio analysis to the next level by categorizing inventory into “meaningful groups,” and then recomputing those same ratios for next-level insight.
Selection of meaningful groups depends on the particular business. For example, a soda-pop distributor might utilize generic categories such as cans versus bottles. Taking things one step further could also group caffeinated beverages vs. noncaffeinated; and even further within with diet caffeinated colas, vs. regular caffeinated colas.
Categorization matters because with this critical step, management can begin to have better insight into what’s actually happening with inventory. From that data, a number of insights and related action steps can be implemented, including increasing demand through targeted marketing, analyzing and possibly consolidating vendors to achieve pricing/quantity discounts or even optimizing reorder points.
Turnover data should be compared to industry peers to both ask questions and, separately, understand your company’s performance. Through this objective comparison, it may become clear what can be optimized.
Understanding and regularly reviewing ratios is the opposite of inventory opacity. Simply put, you’ll be able to influence how resources are performing so that you can more quickly adapt and respond to changes in the marketplace. It also frees up cash to be invested in more than just inventory!
Financial analysis of inventory can be challenging, and it may not be clear where to start or what to focus on first. Clayton & McKervey can help provide resources and interpret results. Contact us today to learn more.