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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 Chances of product being outdated or out of fashion especially in case of consumer goods;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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Financial Accounting Topics


  Introduction to Accounting
 ----------------------------------------------------------------------------
  Transactions and Accounting Equation
----------------------------------------------------------------------------
  Analysis of Business Transactions
----------------------------------------------------------------------------
  Journal, Ledger and Trial Balance
----------------------------------------------------------------------------
  Accounting for Bills of Exchange
----------------------------------------------------------------------------
  Special Journals
----------------------------------------------------------------------------
  Cash Book
----------------------------------------------------------------------------
Bank Reconciliation Statement
----------------------------------------------------------------------------
  Final Accounts
----------------------------------------------------------------------------
  Work Sheet
----------------------------------------------------------------------------
  Capital and Revenue Items
----------------------------------------------------------------------------
  Valuation of Inventories
----------------------------------------------------------------------------
  Accounts of Non-profit Making Organizations
----------------------------------------------------------------------------
  Statement of Cash Flows
----------------------------------------------------------------------------
  Accounting Ratios Analysis
----------------------------------------------------------------------------
  Depreciation, Provisions and Reserves
----------------------------------------------------------------------------
  Accounting Dictionary
----------------------------------------------------------------------------
  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
----------------------------------------------------------------------------
  Cost Volume Profit Relationship
----------------------------------------------------------------------------
  Variable Costing System
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  Materials and Inventory Cost Control
----------------------------------------------------------------------------
  Activity Based Costing System
----------------------------------------------------------------------------
  Standard Costing and Variance Analysis
----------------------------------------------------------------------------
  Balanced Scorecard
----------------------------------------------------------------------------
  Capital Investment Analysis/Capital Budgeting
 
 

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