What is the inventory turnover ratio?
Inventory turnover ratio that measures the number of times on average a company sells inventory during the period and then also the average days to sell the inventory that represents the average number of days in which the company has inventory on hand.
The inventory turnover ratio here now that is defined here as the cost of goods sold divided by the average inventory.
This ratio is related to activity, that is why also called activity ratio or efficiency ratio.
Now the inventory turnover ratio is a common financial ratio that’s used particularly in the retail sector because it measures how many times a firm is able to sell through its existing inventory.
Now inventory turnover is actually a type of what we call activity ratio and an activity ratio is a general category in which an inventory turnover actually falls under.
So there’s a number of different activity ratios but a general activity ratio is all designed to measure how well a company is able to take things like assets. Things that it owns that provide value and able to ultimately turn those into cash or sales revenue.
We’re taking a look at things that the company owns that has some type of value and we’re trying to determine how effective or successful the firm is at utilizing those assets and generating sales. Revenue which of course we look commonly at inventory particularly for a retail type firm.
Let’s dive into the inventory turnover ratio, first off all, let’s kind of go into how do you calculate inventory turnover. Well, inventory turnover you need two variables; the first thing you need is the costs of goods sold.
Instead of the cost of goods sold you might see the costs of goods manufactured costs of goods produced there’s a number of different terms you can use the cost of goods sold is the common line.
The income statement for this particular variable here. We need this one first and of course, it’s going to be on the income statement right below revenues.
These include all of the different costs associated with actually generating those sales revenues. Now we’re going to divide this figure in the formula section.
We’re actually going to divide it by average inventory and average of course being an average of two different numbers.
Advantage of inventory turnover ratio
- A higher value of this ratio is better.
- It helps to check the efficiency of a company.
- This ratio provides the technique of optimal use of inventories.
- It provides insight, how a company managing its stocks.
- This ratio helps businesses to make better decisions about pricing, manufacturing, and all other aspects of the company.
- Suggest balancing and optimizing the demand and supplying chain.
- It helps to improve forecasting accuracy.
- Turn the mind to review the stagnant inventory to optimize sales.
Read|Asset Turnover Ratio
Disadvantage of inventory turnover ratio
- A low-value ratio means weak sales.
- Sometimes, the high value of this ratio turns to insufficient inventory.
- Values vary from heterogeneous industries to industries.
Formula of inventory turnover ratio
It’s a snapshot of a firm’s position at a specific point in time so we can’t get the average inventory looking at the inventory on a specific date.
What you’re going to need is you’re in need of two numbers for inventory and so you can usually get a beginning and an ending inventory.
So let’s say for example you’re trying to calculate inventory turnover for a given year. Well, what you can do is take the beginning inventory at the beginning of the year and then take the ending inventory or the beginning inventory for the next period.
And then add those numbers together divide them by 2 and resultant will get average inventory.
So let’s walk through a quick example:
Let’s assume a company has its inventory costs at the beginning of the year were $175,000 and worth $225,000 during the current year. Inventory costs at the end of the year of $50,000.
Cost of goods sold = $175,000 + $225,000 – $50,000 = $350,000
Average inventory = $175,000 – $50,000 = $125,000
Inventory turnover ratio = $350,000 / $125,000 = 2.8
Interpretation and Analysis of Stock Turnover Ratio
We can talk about the meaningfulness of that value so let’s say that we have the cost of goods sold of $350,000. That is the value of the cost of goods that we of course use to generate profit or sales revenue first.
And we’re going to divide that by our average inventory and let’s say that we determine our average inventory to be a hundred and twenty-five thousand dollars well which means that we have an inventory turnover ratio of 2.8 as given in above example.
Contrary to other variables, where we get a percentage of some kind the inventory turnover is not a percentage so this is multiple.
So we have 2.8 and what this means is that we actually in a given accounting period. So whatever period that we’re using let’s say it’s for the year. We have sold through our inventory 2.8 times, so the value of our inventory.
We’ve sold that through almost three times in a given year. Now the question is this a relatively strong inventory turnover ratio helpful.
Again you want to compare it to past periods. You want to do a comparison between other firms in the industry. You want to be cautious of two things one of which is obvious and the other one might not be.
So obvious so one is when you have a relatively high inventory turnover ratio. Conventional wisdom would be that you know if you have an inventory ratio that is 10 15 20 sounds. Really really good obviously a company if you’re selling through inventory relatively quickly or faster than usual. You’re going to generate more sales revenue which is going to translate into greater profitability.
The thing that you need to think about is well what conditions exist that would cause you to sell through your inventory at a rate of 15 x or 20 x. You have to look at two variables one of which is we are having stock-outs which means that we simply don’t have enough inventory available.
so we don’t have enough of the things that people really like and as a result, we’re missing opportunities and so people are coming into our stores.
We don’t have enough inventory there being that the things are flying off the shelves, but we’re missing sales.
We have lost opportunities and people are going to other companies. Most likely to be able to find the products that they want to purchase.
So inventory turnover ratio that is too high can actually reveal that we’re missing managing our inventory that we are not acquiring enough of it. And that could be problematic the other thing.
It could reveal besides stock-outs is. It could actually indicate that our prices are too low again. If we are selling through inventory and a very quick pace.
We may have an opportunity to actually increase the sales price which logically would decrease demand for that product.
However, sometimes the spread or the difference between the price of the product.
What we acquire for may be enough for us to actually overcome that loss in the number of items sold. If we can capture more value by the sale of a smaller number of products that actually are beneficial for us.
Because of the fact that we no longer have as much of the kind of administrative support functions that go along with. You know servicing more customers so there are fewer returns to deal with.
There are fewer customer contact points to deal with. And that can actually be beneficial for us. Now the other indication or the other possibility is where we have a very low inventory turnover ratio.
This is a little bit more obvious if one is low so there’s a couple of things that you can think about. If you see one that’s lower than other companies.
I don’t mean low by a couple of percentage or a couple of points. I’m talking kind of more significant movements.
If you have an inventory turnover relationship ratio that’s really low. One of the things is you’re looking at obsolete inventory. So we simply don’t sell or are not selling things that are in demand.
As a result, our inventory is not moving a great deal. That is a very huge problem especially for a retailer where the revenue that we derive is primarily based on being able to sell products to come to customers.
Then of course generate revenues and generate profitability. In the long term that’s a very big issue. We start to look at well, why is the inventory not moving?
What are the products that we’re selling? Are they obsolete? Of course, inventory, although it’s an asset.
It doesn’t provide us with any value in its present form. It’s all about converting it into sales revenue.
Ultimately, cash in which the firm can use the inventory that’s possessed in that form. We incur the cost of maintaining it. We ensure it there’s a risk of it becoming stolen, becoming damaged, and then ultimately obsolete. Particularly, if it’s a technology product.
You want to keep in mind those competing dynamics here, of course, you don’t want it an inventory turnover ratio that is far too low. But you also want to manage it, so your inventory is not flying off the shelves.
and you’re not talking fast enough to be able to accommodate customers who still want those particular products you