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:
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Definition of
Inventory Turnover Ratio (ITR)
-
Components of the Ratio
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Formula of Stock Turnover or Inventory Turnover Ratio
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Example
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Significance of ITR
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.
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.
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] |
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
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. |
