Anjali Nair

Inventory turnover ratio can be defined as a financial ratio which indicates how many times a company’s inventory has been sold and replaced in each period of time. The number of days taken to sell the inventory on hand can be then be determined using the inventory turnover formula and the number of days in the period.
 
Calculating inventory turnover can help businesses for making better decisions about pricing, production, marketing, and inventory purchases.
 
Low sales and surplus inventories are indicators of a slow turnover ratio. Therefore, a higher ratio suggests higher sales /lack of inventory. High-volume, low-margin industries like retail and supermarkets also have the largest inventory turnover.
 
Inventory Turnover Ratio Formula
The formula for the Inventory Turnover Ratio is:
 

 
Where,
 
Cost of Goods Sold:
The cost of goods sold is defined as an expense incurred from the direct production of a product. This expense will include the expenses of raw materials and labour. The cost incurred in a merchandising company is usually the actual amount of the finished product also includes any applicable shipping costs paid by a merchandiser to a manufacturer or supplier. The cost of goods sold is appropriately determines both kinds of companies by using an inventory account or list of raw materials or items acquired for production.
 
Average Inventory:
The average cost of a set of products across two or more time periods is defined as average inventory and considers the beginning inventory balance at the beginning of the financial year and the ending inventory balance at the end of the same year.
The average cost of items will result in sales and is calculated by dividing these two account balances in half. Average inventory need not be determined on a yearly basis. This can also be done on monthly or quarterly basis, depending on the specific analysis used to evaluate the inventory account.
 
How to Calculate Inventory Turnover Ratio?
Firstly, how to derive the value of Cost of goods sold?
Cost of goods sold is derived by reducing the profit from the revenue generated or in other words reducing profit from sales.
Profit refers to gross profit because net profit includes indirect expenses that cannot be attributed to an inventory.
Considering the below example, the revenue from operations is Rs. 1,20,000 and therefore 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 value of goods sold derived by unloading the profit margin from the sales.
There can also be a case where you may incur a loss on sale of inventory. Then, therein case, the value of goods sold is derived by adding the gross loss to the cost of goods sold.
Now say finished goods worth of 1,20,000 was sold for Rs. 1,00,000. Here, the gross loss is Rs. 20,000. therefore, the cost of goods sold in this case should be calculated as below.
Cost of products 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 which a business has on hand over a longer period and is calculated by arriving an average of stock at the start and end of the period.
 
Formula to calculate average inventory
Average inventory is calculated as
Opening stock+ Closing stock / 2
For example, inventory at the start of the year is Rs. 1,25,000 and value of inventory at the top of the period the period is Rs. 1,75,000
Thus, average inventory is 1,50,000 (1,25,000 + 1,75,00/2)
Example of inventory turnover ratio
Cost of goods sold -4,50,000
Inventory at the beginning -1,25,000
Inventory at the end - 1,75,000
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.
 
Thus, the average inventory.
 
            = (Opening inventory + closing inventory / 2)                       
 
            = Rs. (1,25,000 + Rs. 1,75,000)/ 2
 
            = Rs. 1,50,000
 
Therefore, 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.
 
Importance of Inventory Turnover Ratio
·        Knowing how quickly inventory sells, how well it matches market demand, and therefore the way its sales compare to other products in its class category is one way to evaluate corporate performance. Because inventory turnover could also be a business’s principal source of revenue, analysts use it to gauge product effectiveness.
·        Higher stock turns are advantageous since they indicate product marketability and lower holding costs, like rent, utilities, insurance, theft, and other expenses associated with keeping products in stock.
·        one more reason to seem at inventory turnover is to compare a company to others in the same industry. Companies measure their operational efficiency by checking if the inventory turnover is on pace with, or have even exceeded, the industry standard benchmark.
·        Inventory turnover could also be a metric that indicates how quickly a company’s sales inventory moves. The speed is often viewed as a barometer of corporate success. Fast-moving inventory retailers tend to outperform. the upper the holding cost, the longer the company is holding the inventory. during this circumstance, customers will not return to the store.
·        Low turnover/sales and excess inventory are all signs of overstocking. the items given or inadequate marketing could be the cause of such a predicament.
·        When the ratio is high, it states the sales are robust or that inventory is low. The latter may end during a business loss.
 
Interpretation of Inventory Turnover Ratio
 
Good Inventory Turnover
What constitutes a “good” inventory turnover will vary relying on the industry. Generally, companies which store relatively affordable products will have greater inventory turnovers. Moreover, sectors that stock costlier items—where buyers typically take longer to form a purchase decision—would have lower inventory turnovers. to figure out whether inventory turnover ratios are favourable or negative, they analyst must compare to the industry and competitors of the company.
 
High Inventory Turnover Ratio
A high inventory turnover ratio indicates that an organization has effective inventory control methods in place, also as strong sales procedures.
Aiming a high inventory turnover is always a goal for businesses. After all, a high inventory turnover minimizes the number of capital invested in inventory, enhancing liquidity and financial health. therefore, maintaining a high inventory turnover decreases the danger of spoilage, damage, theft, or technological obsolescence rendering their products unsellable. However, a high inventory turnover is caused by a company’s insufficient inventory, which suggests it's missing out on prospective sales.
 
Low Inventory Turnover Ratio
It is also conceivable for a business to be at a negative or low inventory turnover ratio and suggest a scarcity of demand, an outmoded product, or a poor sales/ inventory policy, among other things. Low inventory turnover ratios will put your company at an obstacle and may lead to a variety of problems. Stock accumulation leads into expensive maintenance and handling costs. Risk of a product becoming obsolete or out of favour, within the buyer products business.
 
Perishable Goods
Businesses must make sure about inventory movement while dealing with perishable and time-sensitive items. Items like milk, eggs, trending or seasonal clothing, and magazines. The longer this stuff are kept in inventory, the additional money the company loses. Unsold inventory and lost revenues would result from an overstock of such things, especially as seasons change and stores refill with fresh, seasonal inventory. Obsolete inventory is mentioned as dead stock and is unsold inventory.