Definition, Explanation and Use:
Inventory turnover ratio is often linked with the measurement of profitability. Though this ratio does not in itself measure profitability, but an increase in the rate of turnover invariably causes an increase in net profit, and vice versa. The inventory figure may be average inventory or the closing inventory; the earlier figure is obtained by adding together the opening and closing inventory and halving the total. If opening inventory is not known, then there is no option but to base the calculation on closing inventory only.
As inventory is generally valued at cost so in inventory turnover ratio both numerator (sales) should also be at cost price to form a logical relationship. As sales include an element of profit so we use cost of sales in the calculations.
Click on Analysis of Financial Statement of a Business to read the solved example of inventory turnover ratio.
Which Ratio is Better?
Higher inventory turnover ratio is usually preferred. However the high inventory turnover ratio should not be due to too low inventory levels resulting in stock out. In other words, carrying inadequate inventory reduces the carrying costs however stock out may result in reduced profits due to lost sale.
A low inventory turnover, on the other hand, is usually due to lower sales, overstocking, obsolescence and weaknesses in the marketing or distribution efforts. However, in some cases a low turnover rate may be acceptable; for instance inventory may be accumulated in anticipation of rapid increase in inventory prices or shortages. This could also be in anticipation of higher sales in the following period as a result of a price-cutting campaign to be launched. As investment within inventory items yields no returns so carrying inventory more than requirements should be avoided.
Inventory Turnover in Days (Stock/Inventory Holding Period):
If inventory turnover rate is multiplied by 365 then it gives inventory turnover in days. This shows the average number of days which elapse between purchasing and selling an inventory item. This period when compared with other businesses in the same trade provides an indication of the efficiency with which a company manages its inventory. An efficient company will maintain as little inventory as possible whilst ensuring that sufficient inventory is always available to satisfy customers’ demand. Excessive inventory should be avoided as it unnecessarily ties up the company’s money in carrying the unwanted inventory.