There are multiple finance ratios that are resorted to for assessing various business activities. Perhaps the most important among them is the inventory turnover ratio, which is unique in evaluating your business operations. This ratio is also referred to as a stock turnover ratio. This ratio analyses and accurately calculates the effective management of your inventory. This ratio helps you to monitor the volume of stocks sold and the number of times the sold stocks have been replaced by fresh inventory within a specific time frame. The inventory ratio formula involves dividing the value of the products sold by the average or total inventory.
Popularly termed the efficiency ratio, this ratio indicates if the volume of inventory exceeds the volume of sales. These details about the turnover help you to make more appropriate decisions. These decisions could be with regards to manufacturing, purchase of new inventory, pricing the inventory differently as well as devising new marketing strategies to develop the business further. Have you always wondered about what is inventory turnover ratio? It is a ratio that reflects the number of times your business has made a sale and replenished the sold products with fresh inventory. This is often calculated for a fixed duration of time. If the turnover ratio is a slow one, it implies that your business is experiencing poor sales. If the turnover ratio is a fast-paced one, it implies your business is enjoying a good volume of sales. It could also mean you need to have more inventory ready on hand.
Did you know?
The inventory turnover ratio is ranked above all other ratios because it enables a business to strategise in accordance with the results it computes.
The Formula to Calculate Inventory Turnover Ratio
The inventory turnover ratio formula is as follows:
Inventory Turnover = Cost of goods sold / Average value of the inventory.
The cost of goods sold is self-explanatory.
The average value of the inventory means the total inventory at a given point of time (minus) the total available inventory at the end of a given point of time.
You can also calculate inventory turnover in the following method:
Add the inventory on hand at the start of a given time frame to the inventory on hand at the end of a given time frame. Once you add them and get the total amount, divide them by two (2) to get the average inventory.
Now divide the sales that have taken place by the average inventory you have calculated.
What is the Meaning of Cost of Goods Sold?
Every product that is manufactured involves costs. Some of these are direct costs, while others are indirect costs.
The cost of goods sold gives you an understanding of all the direct costs that are involved in the manufacturing of a product or service.
Some of the direct costs include:
- Cost of the materials
- Cost of labour employed to make those products
- Direct overheads costs
- Costs for storage of the materials and products
- Expenses related to depreciation in some cases
- These types of direct costs are subtracted from the sales revenues to understand the total amount of gross profits to your business.
Some of the indirect costs include:
- Administration expenditures
The key objective of understanding the cost of goods that are sold is to understand the real cost of the inventory that is sold within a fixed time frame.
Also Read: Learn About Safety Stocks
How to Calculate the Value of Cost of Goods Sold?
One of the simplest ways to calculate the value of the cost of goods sold is as follows:
Add the inventory at the start (of a certain time) to the purchases made (during that same time frame). From this sum, you subtract the inventory on hand (at the end of a given time frame. This will give you the cost of goods sold, e.g. you have stocks valued at ₹80,000, which are sold within a specified time frame of ₹1,00,000. The value or gross profit of goods sold is ₹20,000. If your stocks cost ₹1,00,000, and you sold them for ₹80,000, your gross loss amounts to ₹20,000.
To understand the value of the cost of goods sold, you will have to understand the inventory costing methods that an organisation implements. There are three different ways in which an organisation resorts. These are as follows:
The First In First Out method (FIFO) – In this case, the products manufactured at the initial stages of production are sold on priority. In case of a price rise, the organisation tends to experience higher net revenues with this method.
The Last In First Out method (LIFO) – The latest manufactured products are sold as a priority. In case of a price rise, the organisation’s net income will reduce in such a situation.
Average inventory and its formula:
The average inventory method involves taking an average price of all the inventory on hand. You calculate this by adding the opening stocks to the closing stocks and dividing the sum by 2, e.g. your opening stock is valued at ₹40,000, and your closing stock is valued at ₹60,000. You add the two i.e. ₹40,000 plus ₹60,000 = ₹1,00,000. Now you divide this sum by 2 to get 50,000. So your average inventory is valued at ₹50,000.
Let us now understand the working of an inventory turnover ratio:
Total cost of goods sold
Value of inventory at the start
Value of inventory towards the end
An inventory turnover ratio example:
Cost of the goods which are sold / average inventory
₹(1,00,000 plus ₹5,000) / 2 = ₹87500
Inventory turnover ratio = 2,00,000 / 87,500 = 2.28
The turnover of your stocks is 2.28 times the stock of your goods which have been sold.
The Importance of the Inventory Turnover Ratio
Every business maintains stocks which include finished products that are ready to be sold as well as raw materials. Inventory of any business includes both the finished products and the raw materials during a specific time frame. Inventory turnover implies the rate at which your stocks are being sold. The inventory turnover ratio assesses the effective manner in which an organisation can procure raw materials, allocate them towards manufacturing and make a sale of the end products.
The above details outline the importance of an inventory turnover ratio. This ratio gives clarity on the inventory which is sold or is kept in excess, which in turn indicates the healthy or slow operations of an organisation. This enables a business to change appropriate plans in the marketing and sale of its products. Use this for all blogs going forward unless required to mention features of the KB app-