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# Inventory / Stock Turnover Ratio:

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## Definition and Explanation:

Inventory turnover ratio or Stock turnover ratio indicates the velocity with which stock of finished goods is sold i.e. replaced. Generally it is expressed as number of times the average stock has been "turned over" or rotate of during the year.

A slow inventory movement has the following disadvantages:

1. Blocking of scarce funds which could be gainfully employed elsewhere;
2. Requiring more strong space resulting in higher maintenance and handling costs;
3. Chances of product being outdated or out of fashion especially in case of consumer goods;
4. During storage for excessive period quality may deteriorate due to inherent factors like rusting loss of potency etc.

Similarly insufficient level of inventory is also dangerous because it may be responsible for the loss of business opportunity. Thus for each item of stock minimum average and maximum levels should be fixed carefully.

## Formula:

Following formula is used to calculate this ratio:

Cost of goods sold / Average inventory at cost

Where Cost of goods sold = Sales - Gross profit or + Gross loss

or

Opening stock + Net purchases + Direct Expenses - Closing stock

and

Average inventory = (Opening stock + Closing stock) / 2

However in the absence of required information any one of the following formula may be substituted as:

Inventory turnover ratio = Net sales / Average inventory at cost

or

Net sales / Average inventory at selling price

or

Net sales / Inventory

## Interpretation:

High turnover suggests efficient inventory control, sound sales policies, trading in quality goods, reputation in the market, better competitive capacity and so on.

Low turnover suggests the possibility of stock comprising of obsolete items, slow moving products, poor selling policy, over investment in stock etc.

## Inventory Conversion Period:

For better understanding it is of interest to know that on an average how many days were taken to dispose off average inventory? It is known as inventory conversion period and is calculated as:

Inventory conversion period = Days in the year/Inventory turnover ratio

or

No of days in the year x Average inventory at cost/Cost of goods sold

## Example:

From the following particulars calculate (1) Inventory turnover ratio and (2) Inventory conversion period.

 \$ Cost of goods sold 4,50,000 Opening stock 1,25,000 Closing stock 1,75,000

Solution:

(1) Inventory turnover ratio = Cost of goods sold / Average inventory

= 4,50,000 / 1,50,000*

= 3 times

*(1,25,000 + 1,75,000) / 2

(2) Inventory conversion period = No. of days in the year/Inventory turnover ratio

= 365 / 3

= 121.66 days (say) 122 days.

Alternatively:

= 365 × Average inventory / Cost of goods sold

= 365 × 1,50,000*/4,50,000

= 121.66 days (Approx.) 122 days.

*(1,25,000 + 1,75,000)/2

More study material from this to

## More study material from this topic: Meanings, Nature and Usefulness of Ratios Analysis Interpretation of Ratios Important Factors for Understanding Ratios Analysis Significance and Usefulness Ratios Analysis Classification of Ratios Analysis of Short Term Financial Position or Test of Liquidity Current Ratio Quick/Acid Test/Liquid Ratio Absolute Liquid Ratio Inventory/Stock Turnover Ratio Debtors / Receivable Turnover Ratio Creditors / Payables Turnover Ratio Working Capital Turnover Ratio Profitability Ratios Gross Profit Ratio (GP Ratio) Operating Profit Ratio Net profit ratio (NP ratio) Earnings Per Share Ratio Operating ratio Expense ratio Solvency ratios - Test of Long Term Solvency Debt-equity Ratio Debt Service Ratio or Interest Coverage Ratio Fixed Assets Ratio Debts to Total Funds or Solvency Ratio Reserves to Capital Ratio Capital Gearing Ratio Proprietary Ratio Accounting Ratios Formulas Limitations of Ratios Analysis

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