Inventory Turnover Ratio

The ratio of inventory turnover is an asset turnover ratio, or rather a percentage that depicts the monetary relationship between sales and the inventory. Basically, businesses exist because of sales and profit. The cycle of business is three-fold and involves raw material, production and sales. In the raw material and production, a volume of money is invested. The sales in-contrast depict the profit of the firm. The turnover ratio is a cost accounting concept that depicts the total number of times the inventory is sold during one accounting year.

Turnover ratio depicts the relation between the rate of sales and the rate of production. From the market economics point of view and consumer economics, and even as per some micro economic theories, the inventory should always be equal to the total sales. Now one very important fact that I wish to point out is that in theory, the sales cost is usually derived on costing principles. That is the sales value is a total of all material and labor cost, plus overheads and an additional margin of profit. The market sales value is a bit higher than this value. In order to adjust the market value some small accounting concepts and adjustments are used. Some additional methods such as LIFO, FIFO, budgetary control measures may also come into the picture.

Inventory Turnover Ratio: Formula

The turnover ratio formula is fairly simple, and the formula to calculate this ratio is given here with an example for better illustration.

Inventory turnover ratio = sales / inventory

Let's take a turnover ratio example,

sales = 100,000
inventory = 80,000

Therefore, turnover ratio = 100,000 / 80,000

Answer: 1.25 (can also be denoted as 5:4)

Though the best ratio is considered to be 1, the inventory side is usually a bit higher, as it ensures that the business is able to sell even during shortages, market crisis or other such conditions. The objective of every firm is to thus bring down the ratio to 1, though not exactly 1 and keep a small margin of inventory over 1. The product will at times will also appear in decimals.

Importance of Turnover Ratio Analysis

The basic importance of inventory turnover is that it establishes a very firm relation between the inventory and sales. The figure in itself is a nice indicator of several performances.

First and foremost, it points out to the investment in an inventory and sales performance. Sales performance should be as good as inventory investment. The lower the product of the division, the better is the inventory being utilized. A rise in the product indicates that the sales is not performing well. This figure is not only an indicator to the inventory management but also to investors and creditors.