Inventory Turnover Ratio: Why It Is Important And How To Calculate It

Inventory turnover ratio is the number of times a business sells and replaces its inventories during a given period. It takes into consideration the cost of goods sold on its average stock for that period.

A high inventory turnover ratio typically indicates that stocks are sold faster and a low turnover rate means the business is experiencing weak sales and excess inventories, which possibly would be challenging for a business.

Inventory turnover can be compared to historical turnover ratios, planned ratios, and industry averages to assess the level of competitiveness and intra-industry performance. The rate of Inventory turnover varies significantly by industry. 

How to Calculate Inventory Turnover Ratio


We can calculate inventory turnover ratio by dividing the cost of goods sold (COGS) for a period by the average stock for that same period. The formula is clearly stated below:

Inventory Turnover Ratio Formula  = (Cost of Goods Sold)/(Average Inventory)

Average Stock is calculated by adding the opening and closing stock, then divide by 2.

For example:

The cost of goods sold by Trending Accounting Manufacturing Company for the current year is $5M. The company’s opening stock was $600,000 and closing stock was $400,000. Find the rate of Inventory turnover.

Answer

To solve this question, you must first ascertain the average stock. Given the stock balances, the average cost of inventory during the year is calculated at $500,000 ($600,000 + $400,000 = $1,000,000 ÷ 2 = $500,000.

Therefore, $5,000,000 ÷ $500,000 = 10

Hence, stock turnover for the period is rated at 10 times.

What is Cost of Goods Sold?


This is an expense suffered from directly creating a product. It includes the raw materials and labor costs. Be that as it may, in a merchandising enterprise, the cost incurred is often the real cost of the end-product (including cost of shipping if any is applicable) purchased by a merchandiser from a manufacturer or a supplier.

What is Average Inventory?


Average inventory or average stock is the average cost of a set of goods in a specified time periods. It considers the opening inventory balance at the beginning of the business year plus the closing inventory balance of the same year.

These two account balances are then divided by two to arrive at the average inventory.

Average inventory does not have to be calculated every year; you can calculate it on a monthly or quarterly basis, and it is dependent on the specific analysis necessary in order to evaluate the inventory account.

Turnover Days in financial modeling


Here is a sample of calculating inventory turnover days in a financial model. As shown in the screenshot below, the 2015 inventory turnover days is 73 days, which is equivalent to inventory divided by cost of goods sold, times 365. It can be calculated by dividing the inventory days ratio by 365 and flipping the ratio. From this example, stock turnover ratio = 1 / (73/365) = 5. It can be concluded that the company can sell and replace its stock of goods five times a year.

Inventory Turnover Ratio: Why It Is Important And How To Calculate It


What Is a Good Inventory Turnover Ratio?


A good inventory turnover ratio is between 4 and 6. It indicates that there is a balance between restock rate and sales, although it varies for different businesses. It further indicates that you will neither be out of stock nor have large quantity of unsold goods filling up your store.

Calculating the turnover ratio for each one of your products will help you determine the needs and wants of your customers while keeping your business financially stable

Low vs High Turnover Ratio


Low – your product or service is selling slowly if it has a low inventory turnover rate. And it is probably overstocked. A low ratio breeds extra expenses:
  1. Outdated items
  2. Spoilt items
  3. High costs of storage
  4. Delays in replacing old stocks with newer stocks that might perform better
  5. Lost business
High – A high ratio indicates that a product sells well, but it could also show that the product is not enough. You should also note that Higher-than-average stock turnover ratio has some disadvantages.

In some cases, continually high ratios for a product lead to frequent shortages and can cause your customers to look elsewhere.

Every high ratio does not often mean you are making a profit on sales. If you are making loss on a product, a high ratio isn’t healthy even if it sells well.

When you have high sales volume, it can result in overstocking products that will expire, become old-fashioned, or lose their warranty.

Importance of Inventory Turnover for a Business


  1. One of the best ways to appraise business performance is to know the speed at which product sells, how effectively it responds to the request of the market, and how its sales stack up to other products in its class group. Businesses depend on inventory turnover to examine product effectiveness, as this is the business’s main revenue stream.
  2. Higher stock turns are advantageous because they indicate product salability and reduced holding costs, namely: rent, utilities, insurance, theft, and other maintenance costs.
  3. Lastly, another importance is to draw a comparison between a business with other businesses in the same line of business. Companies assess their operating efficiencies based upon whether their stock turnover is placed on an equal footing with, or exceeds, the average benchmark set per industry standards.
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