Inventory. Does this word haunt you? Your inventory is all your products that you have on hand that you have not sold yet. Inventory is tricky because it is cash lying around in the form of products.
How much of your inventory that you sell is directly related to the health of your fashion business? This is where your inventory turnover ratio comes into play. This ratio measures how effectively you manage your inventory, taking into account your costs of goods sold in a certain period of time.
This calculation becomes more important in businesses that are weighed down by large investments in excessive amounts of inventory; the fashion industry is a top contender in the crime of overproduction.
I’ll make this as short and sweet as possible.
The inventory turnover ratio measures how many times your average inventory is turned over in a certain period of time. In layman’s terms, it measures how many times a company sold its total average inventory dollar amount during a certain period, usually a month or a year.
To calculate your inventory turnover ratio, you take your costs of good sold and divide it by your average inventory.
Inventory Turnover Ratio = Costs of Goods Sold ÷ Average Inventory
Your costs of goods sold (COGS) should be the total amount of money you have spent in directly creating your product (material, fabric, closures, production, etc.). The only tricky thing to remember when calculating your cost of goods sold is that it only includes purchases that are directly related to creating the product. Things such as product photography or shipping do not count towards cost of goods sold.
Your average inventory amount is how much inventory, in terms of dollar signs, you have sitting around during a certain time period. Since fashion is heavily affected by seasons and different times throughout the year, you will not only want to use your ending inventory amount. This could also give a false outlook into your own business, which could land you in some trouble.
To avoid that mistake, you will need the amount of inventory that you started with in the beginning of the year and add the ending balance of the year (we are using the time period of a year for this example) and divide it by 2 (that numbers stays constant). Using this method will help you get a more accurate analysis of your fashion business’ actual inventory throughout the year.
To further clarify, your formula will now look like:
Inventory Turnover Ratio =
Costs of Goods Sold
[(Beginning Inventory + Ending Inventory) ÷ 2]
As a quick example if at Heather’s Handbags their COGS was $3000 and the beginning year inventory was $10,000 and the ending year inventory was $12,000.
.27 Times =
[(10,000 + 12,000) ÷ 2]
This would leave Heather’s Handbags with a .27 inventory turnover ratio. Meaning Heather only turns over less than one-third of her inventory, this is not a strong financial position. It would take her over 3 years just to sell the entire inventory she currently has on hand—eek! Through this example, it should be clarified why evaluating the health of your business from all operating sectors is so important.
This ratio can come in handy if you feel like your inventory is growing too quickly or that you are under selling your products. Taking a look at your inventory on hand in comparison to how much money you are spending on creating that inventory opens up a new view into your business. This can provide you insights on whether you should be working on selling more of your products or perhaps making less.
We hope using these small pieces of financial knowledge can motivate you to take the precautionary steps to help grow your fashion business in a healthy way.