What is Inventory Turnover Ratio?
Inventory Turnover Ratio is a ratio that shows how many times an average inventory of a company is sold or replaced during a period, for example, a year. It compares two things, viz., the cost of goods sold and average inventory.
Formula for Calculating Inventory Turnover Ratio
The formula used for calculating the inventory turnover ratio is as follows:
Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory
Where average inventory = (Opening Stock + Closing Stock)/2
Components of Inventory Turnover Ratio
Let’s understand the components of the ratio of inventory turnover.
Cost of Goods Sold
The cost of goods sold here includes the cost of all the materials, labor costs, and overheads that have occurred to produce the goods or services. We may understand that selling and distribution costs and finance costs are not made part of it.
For the purpose of this ratio, we take an average of opening and closing inventory. Why? We know that inventory is a moving asset and not a fixed asset. Therefore, the levels of inventory keep changing with each transaction; whether it is a sale or purchase, inventory moved to waste, etc. With the advent of sophisticated inventory management software, it is possible to find out the real weighted average inventory it had held during a year.
Interpretation of Inventory Turnover Ratio
The most important thing after calculating this ratio is to interpret and analyze it.
Low Inventory Turnover Ratio
Apparently, the higher this ratio, the better it is. Lower ratios signify a lack of sufficient sales or higher levels of stock. Some smart businessmen purposely keep high ratios, foreseeing a demand rise in their industry or a rise in prices of the stock. This normally is a temporary phenomenon. The best way to judge whether a ratio is up to the mark or not is to compare it with the industry averages.
High Inventory Turnover Ratio
It implies either strong sales and better inventory management, and also better liquidity. But it can also indicate a shortage or inadequate inventory levels, which may lead to a loss in business.