Inventory Turnover or Stock Turnover Ratios
Every firm has to maintain a certain level of inventory of finished goods so as to meet its business requirements. The level of inventory should neither be too high nor too low. Keeping more inventory implies,
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Unnecessary blockage of capital, which can otherwise be profitably used somewhere else.
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Over-stocking requires more space, thus more rent will be paid.
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Chances of obsolescence of stocks are high since consumers prefer the goods of latest design.
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Slow disposal of stocks will mean slow recovery of cash, which adversely affects liquidity.
It is therefore advisable to dispose off inventory as early as possible. On the other hand, too low inventory may mean loss of business opportunities. The inventory turnover ratio refers to the number of times the stock of finished goods is turned over as sales, or sold or replaced. The inventory turnover ratio also known as stock velocity ratio indicates whether inventory has been efficiently used or not. The inventory turnover ratio evaluates the efficiency with which a firm is able to manage its inventory.
Average inventory is calculated by adding the stock at the beginning and at the end of the period dividing it by two.
Generally, the cost of goods sold may not be known from the published financial statements. In such a case, the inventory turnover ratio may be calculated by dividing net sales by average inventory at cost. If average inventory at cost is not known, then inventory at selling price may be taken as the denominator and where the opening inventory is not known, the closing inventory figure may be taken as the average inventory.
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Inventory turnover ratio provides measure of both the quality and the liquidity of inventory in the current assets component. A high inventory turnover ratio indicates efficient management of inventory because the more frequently the stocks are sold the lesser amount of money is required to finance the inventory. A low inventory turnover ratio indicates an inefficient management of inventory. A low inventory turnover implies over-investment in inventories, dull business, poor quality of goods, stock accumulations, accumulation of obsolete and slow moving goods and low profits as compared to total investments.
But too high a turnover of inventory may not necessarily always imply a favorable situation. A high inventory turnover may be the result of very low level of inventory which results in shortage of goods in relation to demand and a position of stock out or the turnover may be high due to a conservative method of valuing inventories at lower values or the policy of the firm to buy frequently in small lots. There are no such rules of thumb or standard inventory turnover ratio for interpreting the inventory turnover ratio. The norms may be different for different firms depending upon the nature of industry and business conditions.
From the above inventory turnover ratio, the average number of days of inventory remaining on hand is computed by dividing the number of days in the year by the turnover of inventories.
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Inventory turnover ratio of Tata Steel for the year ended March 31, 2007 and March 31, 2006 is computed below:
(Rs. in crore)
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2006-07
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2005-06
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Net Sales (Rs. in crore) (A)
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17552.02
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15215.50
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Average Inventory (Rs. in crore) (B)
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1779.81
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1608.40
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Inventory Turnover Ratio (A) ¸ (B)
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9.86 times
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9.46 times
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Tata Steel's inventory turnover ratio is slightly decreased this year. Generally, the inventory turnover ratio is low in the steel industry.
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