Inventory turnover ratio, also known as stock turnover ratio, is used to measure the number of times a business is able to sell and replace its stock of goods during a given time period.
In other words, it is a ratio which shows the number of times a company has sold and replaced the stock or inventory in a given time period.
The inventory turnover ratio is calculated using the following steps:
1. Determine the total cost of goods sold (obtained from annual income statement)
2. Determine the cost of the average inventory, which can be achieved by adding the opening and closing inventory balances and dividing them by two
3. Divide the cost of goods sold by the average inventory
Formula for calculating inventory turnover ratio is
Inventory turnover ratio = Cost of goods sold / Average inventory
Where cost of goods sold = Beginning inventory + Purchases – Ending inventory
Average inventory = (Beginning inventory + Ending inventory ) / 2
By calculating the inventory turnover ratio, a business is able to make better decisions in the areas of pricing, marketing, manufacturing and for purchasing of new inventory.
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Example of Inventory Turnover Ratio
Consider the following for a company Suraj Industries Pvt Ltd.
Cost of Goods Sold – 5,00,000
Beginning Inventory – 1,55,000
Closing Inventory – 2,45,000
Calculate the inventory turnover ratio
Answer:
Inventory turnover ratio = Cost of goods sold / Average inventory
And,
Average Inventory = (Beginning inventory + Ending inventory) / 2
Therefore,
Average Inventory = (1,55,000 + 2,45,000) / 2
= 1,50,000
Inventory Turnover Ratio = 5,00,000/ 1,50,000
= 3.33
This means that the inventory turns over 3.33 times in a year for Suraj Industries Pvt Ltd.
A slow turnover ratio indicates that sales are not happening and excess inventory is in hand, while a high inventory turnover implies faster sales or there is insufficient inventory in hand.
This concludes our article on the topic of Inventory Turnover Ratio, which is an important topic in Accountancy for Commerce students. For more such interesting articles, stay tuned to BYJU’S.
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