Inventory turnover ratio shows how often the company replaces its inventory or how well the company generates revenue out of its stock of goods. This ratio is most importantly used as a performance indicator in retail and manufacturing businesses.
Inventory/stock of goods of a company includes followings:
- Raw materials
- Finished goods
In retail business most of the inventories are finished goods ready for resale. Inventory Turnover ratio indicates the liquidity of inventories. If its high, then it indicates that the management is selling stocks more quickly.
Formula to calculate inventory turnover ratio or ITR
Inventory turnover ratio (ITR) = total sales or turnover / average inventory
Each unit of stock that passes through inventory during the year is added to cost of goods sold when its sold to customers and removed from list of inventories. Due to this reason, comparison of cost of goods sold with the total stock can be a best measure to assess the effectiveness of the management.
Some companies may not have policies to disclose cost of goods sold and gross profits to public. If its not available, you can use the first formula or else cost of goods sold should be used.
Due to this following alternative method can be used by replacing sales with cost of goods sold:
ITR = Cost of goods sold / average inventory value
Average inventory turnover can be calculated by adding stock of goods at the beginning of the year with stock of goods at the end of the year and then dividing the resulting figure by 2.
Formula to calculate average inventory value = (opening stock of goods+closing stock of goods)/2
This ratio shows the number of times a company sells and replaces its stock of goods during the period.
Dividing 365 days by ITR provides an estimate of the average number of days a unit remains in inventory or it measures how many days it takes for stock of goods to turn into sales. Similarly, if you want to calculate in terms of week or months then instead of multiplying with 365, you need to multiply 52 weeks and 12 months as the case may be.
Company XYZ has Rs 10,00,000 in sales and Rs 2,50,000 in cost of goods sold. The average stock of goods is Rs 25000.
Company’s ITR = sales/average stock of goods = 10,00,000/25,000 = 40.
Instead of sales, if you take cost of goods sold into the calculation then its calculated as follows:
Company’s ITR = cost of goods sold/average stock of goods = 250000/25000 = 10
If you want to find it in number of days, then divide 365 with the resulting figure, which is 36.5 days (365/10).
Interpretation of ITR
Inventory turnover ratio is meaningful only when you compare it with industry standards, competitors and prior period figures.
A high ITR is generally considered as positive sign since it typically indicates that the company is selling its finished products very quickly due to higher demand. However, if it’s very high, then it may be a sign that the company may lose sales because stock in hand is inadequate.
On the other hand, if its low then it indicates that the company has weaker sales and demand of the product is low, also called overstocking. If sales are down or economy is under-performing, companies may have low ITR.
Inventory turnover ratio can rise due to number of factors. Suppose sales price of the company’s product rise because of high demand. In this type of case, sales will go up resulting higher Inventory Turnover Ratio.