Inventory Turnover Ratio indicates the movement of the average stock holding of each item of material in relation to its consumption during the accounting period.
It is a basic tool to know how fast a company generates sales from its inventory.
A business firm can have four types of inventory :
- Raw materials– the materials, components, fuels, etc. used in the manufacture of products.
- Work-in-Process (WIP)– partly finished goods and materials, sub-assemblies, etc. held between manufacturing stages.
- Finished goods – completely ready for sale or distribution.
- Consumables – for example, fuel and stationery
The Inventory Turnover Ratio is calculated by applying the following formula :
- The higher the inventory turnover, the better since a high inventory turnover typically means a company is selling goods very quickly, and that demand for their product exists.
- Low inventory turnover, on the other hand, would likely indicate weaker sales and declining demand for a company’s products.
- It highlights slow-moving or obsolete stocks where the action is needed to reduce the stock held.
- It indicates whether the stock holding is consistent with the material required for production.
- It helps in location excessive stocks and by avoiding unnecessary pile-up of stocks, the financial strain on the working capital f the organization can be reduced.
Illustration 1: XYZ Ld. used raw material M’ during the accounting year amounting to Rs. 8,00,000. The value of the opening stock was Rs. 80000 and the value of the closing stock was Rs. 1,20,000. Calculate stock turnover ratio.
Inventory Turnover Ratio = 800000/100000
= 8 times
Stock Turnover Rate in Days
The stock turnover rate in a number of days is calculated as follows: