Inventory Turnover Ratio – Definition, Formula and Example

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Yarab A, Apr-17-2020

Definition of inventory turnover ratio

Inventory turnover ratio is an accounting ratio that establishes a relationship between the revenue cost, more commonly known as the cost of goods sold and average inventory carried during the period. It is also called a stock turnover ratio.

Inventory turnover ratio explains how much of stock held by the business has been converted into sales. In simple words, the number of times the company sells its inventory during the period.

Formula to calculate inventory turnover ratio

Inventory Turnover Ratio = Cost of goods sold / Average inventory

Before we apply the above formula, let’s understand the cost of goods sold, average inventory and how to determine these.

Cost of goods sold

Here, Cost of goods sold is nothing but the cost of revenue from operations. Revenue from operations means your sales. So, the cost of sales is the actual value of inventory which has been converted into sales.

For example, finished goods worth Rs 1,00,000 was sold for Rs. 1,20,0000. Here Rs. 1,20,000 is the revenue generated from the operations and Rs. 1,00,000 is your cost of inventory or cost of goods sold.

How to derive the value of Cost of goods sold?

Cost of goods sold is derived simply by reducing the profit from the revenue generated. To simply put, reducing profit from sales.

Profit here refers to gross profit. This is because net profit includes indirect expenses that cannot be attributed to an inventory.

Considering the above example, our revenue from operations is Rs. 1,20,000 and the gross profit is Rs. 20,000 (Rs. 1,20,000 -1,00,000).  Here, 1,00,000 (revenue – gross profit) is nothing but the cost of goods sold derived by unloading the profit margin from the sales.

There may also be a case where you may incur a loss on sale of inventory. Then, in that case, the cost of goods sold is derived by adding the gross loss to the cost of goods sold.

Let’ say finished goods worth of 1,20,000 was sold for Rs. 1,00,000. Here, the gross loss is Rs. 20,000. So the cost of goods sold in this case should be calculated as below.

Cost of goods sold = Revenue from operations + Gross loss

                               = Rs. 1,00,000 + Rs. 20,000

                               = Rs. 1,20,000

Average inventory and its formula.

Average inventory is an estimated amount of inventory that a business has on hand over a longer period. As the name suggests, it is calculated by arriving an average of stock at the beginning and end of the period.

Formula to calculate average inventory

Average inventory is calculated using the below formula

Opening stock+ Closing stock / 2

For example, inventory at the beginning of the year is Rs. 1,25,000 and value of inventory at the end of the period is Rs. 1,75,000

So average inventory is 1,50,000 (1,25,000 + 1,75,00/2)

Example of inventory turnover ratio

Now that we have understood the inventory turnover ratio formula, let’s calculate it by considering an example.

Cost of goods sold

4,50,000

Inventory at the beginning

1,25,000

Inventory at the end

1,75,000

To calculate the inventory turnover ratio, let’s apply the formula we discussed.

Inventory Turnover Ratio = Cost of goods sold / Average Inventory

We know the cost of goods sold i.e. Rs. 4,50,000 as given in the table.

Let’s now calculate the average inventory.

            = (Opening inventory + closing inventory / 2)

            = Rs. (1,25,000 + Rs. 1,75,000)/ 2

            = Rs. 1,50,000

So, the inventory turnover ratio will be = Rs. 4,50,000 / 1,50,000

                                                                    = 3 times

The result implies that the stock velocity is 3 times i.e. 3 times the stock of finished goods is been converted into sales.

Why Inventory Turnover Ratio is important?

A high inventory turnover ratio implies that a company is following an efficient inventory control measures compounded with sound sales policies. It explains how successful you are in converting the stock into sales. The higher ratio here is a positive sign for any business.

On the other hand, it’s also possible that a company may get adverse or low inventory turnover ratio. This indicates a lack of demand, outdated product or poor selling/ inventory policy etc. Low inventory turnover ratio puts your business into a disadvantage and potentially lead to some of the issues listed below:

  • Working capital blockage which could have been gainfully employed elsewhere
  • Piling up of stocks resulting in high maintenance and handling costs
  • Risk of a product being outdated or going out of fashion especially in the case of consumer goods industry
  • High possibility of quality being deteriorated during storage because of the waiting period.

Read Inventory Valuation to know the different valuation methods and calculations with examples.

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