Definition: The Inventory Turnover Ratio, also called as Stock Turnover Ratio, shows how frequently the inventory is converted into the sales. Simply, this ratio measures the capacity of a firm to generate revenues from the sale of its inventory.
Ideally, the company’s inventory turnover ratio should be compared with the industry average. But however, companies do evaluate their performances against the previous ratios or the planned ratios. The formula to compute the Inventory Turnover Ratio is:
Inventory Turnover Ratio= Cost of goods sold/ Average inventory
Where, Cost of goods sold= (Opening stock + Purchases + Direct expenses and wages + Carriage Inward) – Closing Stock
Average Inventory = (Opening stock + Closing Stock) /2
Note: In case cost of goods sold is not given, the sales amount can be used in its position.
Higher the inventory turnover ratio better is the inventory management of the firm and ensures timely delivery of products to the customers.
Example: Suppose a firm is having an opening stock and a closing stock worth Rs 1,20,000 and 30,000 respectively. The firm incurred the direct expenses of Rs 50,000, then the inventory turnover ratio will be:
Inventory Turnover Ratio = 1,40,000/75,0000 = 1.87 times
Cost of goods sold = (1,20,000+50,000) – 30,000 = 1,40,000
Average Inventory = 1,20,000+30,000 = 75,000