In business, cash on hand, aka liquidity, is more important than having higher inventory levels. This is because cash gives you more options to make money than high inventories. As a result, companies must balance cash in the bank and having inventory sitting on shelves for extended periods. In order to achieve this balance, you need to understand how the capital can best work for the business. The ratio of inventory to sales depends on the industry you are in. Ideally, inventory holdings should be equal to sales, leaving the storeroom empty each day. However, as a rule of thumb, a ratio of 10% to 20% is appropriate.
What Should Inventory to Sales Be?
Inventory to Sales Explained
The ratio of sales to inventory is a measurement that compares sales against what’s in the stock room. Sales will indicate and help measure the amount of inventory your business needs and when it will need it. This is especially true in an industry that is seasonal. The inventory turnover ratio is then used to manage stock levels.
Sales patterns will tell you when you need to spend your cash and how much you will need to spend. This is better known as ordering lead time. Understanding order lead times means that you can accurately predict cash flow requirements. The business principle relies on the company’s inventory levels matching the number of sales or being as close as possible.
Why it’s Important
Forecasting stock requirements based on sales information is the key to managing stock levels. If your business needs to keep inventory on hand, then work towards replenishing it on a “just in time” basis. A same-day turnaround of stock in and out would be ideal. However, a perfectly optimized inventory turnover formula would include stock shipped directly from your supplier to your customer, and a delay before having to pay the supplier.
Inventory management professionals must work to keep money from being tied up in inventory. This is especially true if the demand for your inventory is seasonal or, even worse, subject to styles and trends which have limited appeal. Inventory that can’t be sold can have severe long-term effects on a companies bottom line.
Therefore, implementing and following an inventory to sales ratio safeguards the business from three of its biggest enemies. One, being understocked. Two, being overstocked. Three, having no cash flow. Always be mindful that inventory is one of the biggest expenses that a business can face.
Using a customer’s money to run your business is ideal. The perfect business model is to have customers pay your business before you pay a supplier. This will free up cash for other business operations. Therefore, the entire business will benefit if your supplier offers 30 days, 14 days, or even 7 days to pay.
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