Inventory or Stock Turnover Ratio
Inventory or Stock Turnover is otherwise called as stock velocity. It indicates whether the inventory has been used effective or not. The very purpose of calculating stock turnover ratio is knowing the extend of funds locked up in inventory.
In other words, Stock Turnover Ratio indicates the number of times the stock has been turned over during the period and evaluates the efficiency with which a firm is able to manage its inventory. The following formulae are used to calculate the Stock Turnover Ratio.
NOTE: If stock velocity is to be computed in period (days / months) than the last formula is used.
Average Inventory = (Opening Stock + Closing Stock) / 2
Inventory Conversion Period
It is otherwise called as Average Age of Inventory. An analyst can find the average time taken for clearing the stocks. In this case, the following formula can be used to find the inventory conversion period.
Cost of Goods sold is otherwise called as cost of sales. The main requirements to calculate Inventory / Stock Turnover Ratio are cost of goods sold and average inventory. The cost of Goods sold may be calculated as under.
a. In case of Trading Concern
Cost of Goods Sold = (Opening Stock + Purchase of Raw materials + Direct Expenses) — Closing Stock
b. In case of Manufacturing Concern
Cost of Goods Sold = (Total cost+ Opening Stock Finished Goods) – Closing Stock of Finished Goods.
Total Cost = Raw Materials Consumed + Labour + Overheads
c. If Gross Profit is known
Cost of Goods Sold = Sales – Gross Profit
Generally, the term stock or inventory refers to stock of raw materials, stock of working progress and stock of finished goods.
Average inventory or stock may be calculated as under.
i. If a company is trading or manufacturing seasonal products
= Value of Stock at the end of each month / 12 months
ii. All other business concern
= Opening Stock + Closing Stock
If average stock cannot be ascertained due to non-availability of required information, closing stock may be treated as average stock.
If a company is engaging manufacturing activities, three more ratios are calculated in addition to Inventory/Stock Turnover Ratio. They are Raw Materials Turnover Ratio, Work in Progress Turnover Ratio and Finished Goods Turnover Ratio.
Significance of Inventory / Stock Turnover Ratio
This ratio indicates the degree of effective management of inventory. It means that high stock turnover ratio shows effective management of inventory and vice versa. Only high stock turnover ratio yields more profits. But, this is not true in all cases.
Sometimes, a company has high stock turnover ratio. This is possible due to keeping of low level of inventory in relation to demand or following conservative method of valuing inventories at lower values or the policy of the company of buying inventory in small lots frequently.
In this situation, high profits cannot be earned by the company. Hence, there is a need of further investigation before interpreting the stock turnover ratio to get final results. Besides, there is no rules of thumb or standard inventory turnover ratio.
Reasons for Low Inventory / Stock Turnover Ratio
1. There is over investment in stock.
2. Closing stock is increased just to take the advantage of expected rise in selling price or to meet the estimated rise in future sales.
3. The stock has been valued incorrectly.
4. There is slump in the business.
Impact of Low Inventory / Stock Turnover Ratio
1. Profitability is low.
3. Over stocking requires more go down space.
3. Non-availability of space for other business activities.
4. There are chances of obsolescence of stock.
5. Quality of the produce is affected.
6. Weak cash in hand.