Inventory Turnover Ratio or Stock Turnover Ratio (ITR):

Every firm has to maintain a certain level of inventory of finished goods so as to be able to meet the requirements of the business. But the level of inventory should neither be too high nor too low.

A too high inventory means higher carrying costs and higher risk of stocks becoming obsolete whereas too low inventory may mean the loss of business opportunities. It is very essential to keep sufficient stock in business.

Contents:

1. Definition of Inventory Turnover Ratio (ITR)
2. Components of the Ratio
3. Formula of Stock Turnover or Inventory Turnover Ratio
4. Example
5. Significance of ITR

Definition:

Stock turn over ratio and inventory turn over ratio are the same. This ratio is a relationship between the cost of goods sold during a particular period of time and the cost of average inventory during a particular period. It is expressed in number of times. Stock turn over ratio / Inventory turn over ratio indicates the number of time the stock has been turned over during the period and evaluates the efficiency with which a firm is able to manage its inventory. This ratio indicates whether investment in stock is within proper limit or not.

Components of the Ratio:

Average inventory and cost of goods sold are the two elements of this ratio. Average inventory is calculated by adding the stock in the beginning and at the and of the period and dividing it by two. In case of monthly balances of stock, all the monthly balances are added and the total is divided by the number of months for which the average is calculated.

Formula of Stock Turnover/Inventory Turnover Ratio:

The ratio is calculated by dividing the cost of goods sold by the amount of average stock at cost.
 

(a) [Inventory Turnover Ratio = Cost of goods sold / Average inventory at cost]

Generally, the cost of goods sold may not be known from the published financial statements. In such circumstances, the inventory turnover ratio may be calculated by dividing net sales by average inventory at cost. If average inventory at cost is not known then inventory at selling price may be taken as the denominator and where the opening inventory is also not known the closing inventory figure may be taken as the average inventory.
 

(b) [Inventory Turnover Ratio = Net Sales / Average Inventory at Cost]

(c) [Inventory Turnover Ratio = Net Sales / Average inventory at Selling Price]

(d) [Inventory Turnover Ratio  = Net Sales / Inventory]

Example:

The cost of goods sold is $500,000. The opening stock is $40,000 and the closing stock is $60,000 (at cost).

Calculate inventory turnover ratio

Calculation:

Inventory Turnover Ratio (ITR) = 500,000 / 50,000*

= 10 times

This means that an average one dollar invested in stock will turn into ten times in sales

*($40,000 + $60,000) / 2
= $50,000

Significance of ITR:

Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually a high inventory turnover/stock velocity indicates efficient management of inventory because more frequently the stocks are sold, the lesser amount of money is required to finance the inventory. A low inventory turnover ratio indicates an inefficient management of inventory. A low inventory turnover implies over-investment in inventories, dull business, poor quality of goods, stock accumulation, accumulation of obsolete and slow moving goods and low profits as compared to total investment. The inventory turnover ratio is also an index of profitability, where a high ratio signifies more profit, a low ratio signifies low profit. Sometimes, a high inventory turnover ratio may not be accompanied by relatively a high profits. Similarly a high turnover ratio may be due to under-investment in inventories.

It may also be mentioned here that there are no rule of thumb or standard for interpreting the inventory turnover ratio. The norms may be different for different firms depending upon the nature of industry and business conditions. However the study of the comparative or trend analysis of inventory turnover is still useful for financial analysis.

 

You may also be interested in other relevant articles: Horizontal Analysis or Trend Analysis Trend Percentage Vertical Analysis Limitations of Financial Statement Analysis Accounting Ratios definition, advantages, classifications and limitations Financial Ratio Formulas Profitability ratios: Gross profit ratio Net profit ratio Operating ratio Expense ratio Return on shareholders investment or net worth Return on equity capital Return on capital employed (ROCE) ratio Dividend yield ratio Dividend payout ratio Earnings Per Share Ratio Price earning ratio Liquidity ratios: Current ratio Liquid /Acid test / Quick ratio Activity ratios: Inventory/Stock turnover ratio Debtors/Receivables turnover ratio Average collection period Creditors/Payable turnover ratio Working capital turnover ratio Fixed assets turnover ratio Over and under trading Leverage ratios or long term solvency ratios: Debt equity ratio Proprietary or Equity ratio Ratio of fixed assets to shareholders funds Ratio of current assets to shareholders funds Interest coverage or debt service ratio Capital gearing ratio Over and under capitalization

 

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