The inventory turnover ratio formula
The inventory or stock turnover ratio formula is simple. You just need to divide the company’s Cost of Goods Sold (COGS) over a given period by the average inventory held during that period. The COGS tells you the cost of sales, while the average inventory gives you some idea about how much stock the company held, on average.
Check out the inventory turnover formula below.
Inventory turnover ratio = Cost of goods sold ÷ Average value of inventory
To find the average inventory value, you can simply add the beginning and the ending inventory levels during the period concerned and divide this sum by 2. This leads us to the formula shown below:
Average value of inventory = (Beginning inventory + Ending inventory) ÷ 2
If you know the COGS and beginning and ending inventory levels, computing the stock turnover ratio is extremely easy. Let us discuss an example to make this clearer.
How to calculate the inventory turnover ratio: An example
Say a company has the following relevant data points for the financial year 2023-24.
- Cost of goods sold: Rs. 24,00,000
- Inventory value at the beginning of the financial year: Rs. 5,00,000
- Inventory value at the end of the financial year: Rs. 3,00,000
- Using the above data, let us first find the average inventory before calculating the inventory turnover ratio. The average inventory will be Rs. 4,00,000 [i.e., (Rs. 3,00,000 + Rs. 5,00,000) ÷ 2].
- Substituting this value in the stock turnover ratio formula, we can find the inventory turnover ratio, which is:
= Cost of goods sold ÷ Average value of inventory
= Rs. 24,00,000 ÷ Rs. 4,00,000
= 6
Why is inventory turnover important?
Why is understanding inventory turnover so important? For retailers, especially those with multiple sales channels, optimising stock levels in line with consumer demand is crucial for both profitability and operational efficiency. The inventory turnover ratio is a key indicator of this. Understanding this core metric is essential for optimising your resources.
No retailer wants to waste money and resources on unnecessary storage costs. Likewise, no retailer wants to underestimate consumer demand. So, rather than relying on guesswork, retailers can aim to optimise their inventory turnover rates.
The benefits are numerous. Understanding inventory turnover ratios can help increase profitability and make better long-term business decisions.
What the inventory turnover ratio can tell you?
Knowing the meaning of inventory turnover and how to calculate it is one thing, but it’s also crucial to understand what this ratio tells you. In the simplest terms, the inventory or stock turnover ratio tells you how many times or how frequently a company has to replace its inventory.
It is assumed that such replacement generally stems from the sale of existing inventory. So, a high inventory turnover ratio is considered to be a favourable indicator of a company’s efficiency. Conversely, a low stock turnover ratio may be a sign of overstocking or inefficiencies in product sales. This is a red flag for investors and other stakeholders.
In the above example, an inventory turnover ratio of 6 indicates that in the financial year concerned, the company sold and replaced its inventory 6 times.
Also read: What is trading volume?
What is a good inventory turnover level?
There is no single ideal inventory turnover level. It depends on the company’s usual operational procedures, the industry standard and the nature of the business.
For companies that trade in low-cost, fast-moving goods like groceries, a high inventory turnover ratio of 12 or more may be suitable. However, for businesses with moderately-priced goods that are not as fast-moving, like furniture and appliances, a suitable inventory turnover level would be in the range of 5 to 12. Then, for industries and companies that deal in high-cost speciality products, the stock turnover ratio may be lower than 5.
Limitations of the inventory turnover ratio
One of the key limitations of the stock turnover ratio is that it varies greatly across industries. So, there is no standard scale to tag a ratio as good or bad at first glance. Additionally, the concept of inventory turnover may not translate smoothly to companies with a diverse product mix. High-margin products may be deliberately held for longer to increase the returns, and this could affect the stock turnover ratio.
So, while it can help to assess and factor in inventory turnover, make sure you look into these aspects and understand the nature of the company’s inventory policies in-depth.
Conclusion
Despite these limitations, the bottom line is that the inventory turnover ratio, which is one of the many different efficiency ratios, can be very useful for investors. Other ratios in this category include the asset turnover ratio, accounts receivable turnover ratio and more.
By analysing such efficiency ratios before investing in a company, you can understand its operational efficiency and evaluate its liquidity better. What’s more, you can also gain insights into the company’s profitability and perform a comparative analysis of the entity with its peers.
Related Articles
What is the Capital Adequacy Ratio (CAR)?
What is Debtors Turnover Ratio?
What is current ratio?
What is the PEG ratio formula?
What is PE Ratio?
