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What is Inventory Turnover Ratio?

Inventory turnover ratio is a financial ratio that indicates how many times a company’s inventory has been sold and replaced in a given period. The number of days it takes to sell the inventory on hand may then be determined using the inventory turnover formula and the number of days in the period.

Calculating inventory turnover can help businesses make better decisions about pricing, production, marketing, and inventory purchases.

Low sales and maybe surplus inventories are indicators of a slow turnover ratio. Furthermore, a higher ratio suggests higher sales or a lack of inventory. High-volume, low-margin industries like retail and supermarkets have the largest inventory turnover.

Inventory Turnover Ratio Formula

The formula for the Inventory Turnover Ratio is:

Inventory Turnover Ratio – Cost of Goods Sold/ Average Inventory

OR

Inventory Turnover Ratio – Sales/ Average Inventory

Where,

Cost of Goods Sold:

The cost of goods sold is an expense incurred from the direct production of a product. This expense includes the expenses of raw materials and labor. The cost incurred in a merchandising company, on the other hand, is usually the actual amount of the finished product (plus any applicable shipping costs) paid by a merchandiser to a manufacturer or supplier. The cost of goods sold is appropriately determined in both kinds of companies by using an inventory account or list of raw materials or items acquired for production. 

Average Inventory:

The average cost of a set of products across two or more time periods is known as average inventory. It considers the beginning inventory balance at the beginning of the financial year, as well as the ending inventory balance at the end of the same year.

The average cost of items resulting in sales is calculated by dividing these two account balances in half. Average inventory does not have to be determined on a yearly basis. It can be done monthly or quarterly, depending on the specific analysis needed to evaluate the inventory account.

How to Calculate Inventory Turnover Ratio?

The inventory turnover ratio can be calculated by calculating the cost of goods sold and average inventory. The following illustration will help in understanding the concept better.

ParticularsAmount
SalesRs 8,00,000
Raw MaterialRs 2,20,000
Processing ExpensesRs 80,000
Manufacturing ExpensesRs 40,000
Other Expenses Made to Produce the ProductsRs 20,000
Inventory as on 1st April 2021Rs 2,20,000
Inventory as on 31st March 2022Rs 1,80,000
Cost of Goods Sold
(Raw Material + Processing Expenses + Manufacturing Expenses + Other Expenses Made to Produce the Products)
Rs 3,60,000
(Rs 2,20,000 + Rs 80,000 + Rs 40,000 + Rs 20,000)
Average Stock
(Inventory as on 1st April 2021 + Inventory as on 31st March 2022) / 2
Rs 2,00,000
(Rs 2,20,000 + Rs 1,80,000) / 2
Inventory Turnover Ratio
(Method-1)(Cost of Goods Sold/ Average Inventory)
1.8 times
(Rs 3,60,000 / Rs 2,00,000)
Inventory Turnover Ratio
(Method-2)(Sales/ Average Inventory)
4 times
(Rs 8,00,000 / Rs 2,00,000)

Importance of Inventory Turnover Ratio

  • Knowing how quickly inventory sells, how well it matches market demand, and how its sales compare to other products in its class category is one way to evaluate corporate performance. Because inventory turnover is a business’s principal source of revenue, analysts use it to evaluate product effectiveness.
  • Higher stock turns are advantageous since they indicate product marketability and lower holding costs, such as rent, utilities, insurance, theft, and other expenses associated with keeping products in stock.
  • Another reason to look at inventory turnover is to compare a company to others in the same industry. Companies measure their operational efficiency by seeing if their inventory turnover is on pace with, or even exceeds, the industry standard benchmark.
  • Inventory turnover is a metric that indicates how quickly a company’s sales inventory moves. The speed can be viewed as a barometer of corporate success. Fast-moving inventory retailers tend to outperform. The higher the holding cost, the longer the company is holding the inventory. In this circumstance, customers may not return to the store.
  • Low turnover, low sales, and excess inventory are all signs of overstocking. The items given or inadequate marketing could be the cause of such a predicament.
  • When the ratio is high, it indicates that sales are robust or that inventory is low. The latter may result in a business loss.

Interpretation of Inventory Turnover Ratio

Good Inventory Turnover

What constitutes a “good” inventory turnover will vary depending on the industry. As a general rule, companies that store relatively affordable products will have greater inventory turnovers. Moreover, sectors that stock more expensive items—where buyers typically take longer to make a purchase decision—would have lower inventory turnovers. To determine whether inventory turnover ratios are favorable or negative, they analyst must compare to the industry and competitors of the company.

High Inventory Turnover Ratio

A high inventory turnover ratio indicates that a company has effective inventory control methods in place, as well as strong sales procedures. It explains how effective you are at turning stock into sales. A larger ratio in this case is a good sign for any company.

Aiming for a high inventory turnover is virtually always a goal for businesses. After all, a high inventory turnover minimizes the amount of capital invested in inventory, enhancing liquidity and financial health. Furthermore, maintaining a high inventory turnover decreases the danger of spoilage, damage, theft, or technological obsolescence rendering their products unsellable. However, a high inventory turnover is caused by a company’s insufficient inventory, which means it’s missing out on prospective sales.

Low Inventory Turnover Ratio

It’s also conceivable for a business to have a negative or low inventory turnover ratio. This could suggest a lack of demand, an outmoded product, or a poor sales/ inventory policy, among other things. Low inventory turnover ratios put your company at a disadvantage and can lead to a variety of problems. Stock accumulation leads to expensive maintenance and handling costs. Risk of a product becoming obsolete or out of style, particularly in the consumer products business. Because of the waiting period, there is a high risk of quality degradation during storage.

Perishable Goods

Businesses must be cautious about inventory movement when dealing with perishable and time-sensitive items. Such items are milk, eggs, trending or seasonal clothing, and magazines. The longer these items are kept in inventory, the more money the company loses. Unsold inventory and lost revenues may result from an overstock of such things, especially as seasons change and stores refill with fresh, seasonal inventory. Obsolete inventory, often known as dead stock, is unsold inventory.

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