Definition and Explanation:
Inventory turnover ratio or
Stock turnover ratio indicates the velocity with which stock of finished
goods is sold i.e. replaced. Generally it is expressed as number of times the
average stock has been "turned over" or rotate of during the year.
A slow inventory movement has the following
disadvantages:
- Blocking of scarce funds which could be
gainfully employed elsewhere;
- Requiring more strong space resulting in
higher maintenance and handling costs;
- Chances of product being outdated or out
of fashion especially in case of consumer goods;
- During storage for excessive period
quality may deteriorate due to inherent factors like rusting loss of potency
etc.
Similarly insufficient level of inventory is
also dangerous because it may be responsible for the loss of business
opportunity. Thus for each item of stock minimum average and maximum levels
should be fixed carefully.
Formula:
Following formula is used to calculate this ratio:
Cost of goods sold / Average inventory at cost
Where Cost of goods sold = Sales
- Gross profit or + Gross loss
or
Opening stock + Net purchases +
Direct Expenses - Closing stock
and
Average inventory = (Opening
stock + Closing stock) / 2
However in the absence of required information any one of the following
formula may be substituted as:
Inventory turnover ratio = Net
sales / Average inventory at cost
or
Net sales / Average inventory at
selling price
or
Net sales / Inventory
Interpretation:
High turnover suggests efficient inventory
control, sound sales policies, trading in quality goods, reputation in the
market, better competitive capacity and so on.
Low turnover suggests the possibility of stock
comprising of obsolete items, slow moving products, poor selling policy, over
investment in stock etc.
Inventory Conversion Period:
For better understanding it is of interest to
know that on an average how many days were taken to dispose off average
inventory? It is known as inventory conversion period and is calculated as:
Inventory conversion period =
Days in the year/Inventory turnover ratio
or
No of days in the year x Average
inventory at cost/Cost of goods sold
Example:
From the following particulars calculate (1)
Inventory turnover ratio and (2) Inventory conversion period.
| |
$ |
| Cost of goods sold
|
4,50,000 |
| Opening stock |
1,25,000 |
| Closing stock |
1,75,000 |
Solution:
(1) Inventory turnover ratio =
Cost of goods sold / Average inventory
= 4,50,000 / 1,50,000*
= 3 times
*(1,25,000
+ 1,75,000) / 2
(2) Inventory conversion period
= No. of days in the year/Inventory turnover ratio
= 365 / 3
= 121.66 days (say) 122 days.
Alternatively:
= 365 ×
Average inventory / Cost of goods sold
= 365 ×
1,50,000*/4,50,000
= 121.66 days (Approx.) 122
days.
*(1,25,000
+ 1,75,000)/2 |
