What is Inventory Turnover Ratio?

Inventory turnover ratio of a company determines the frequency of sales happening at a company. The ratio also suggests how efficiently and quickly the management is able to convert its inventory into sales, and how better the company is able to fulfill the orders on time.

The costs associated with retaining excess inventory and not producing sales can prove to be very expensive. Besides incurring storage cost, there is also the interest cost on the money locked up in inventory.

How to interpret inventory turnover ratio

A low inventory ratio is a sign of company's inefficiency in managing its sales and that the company is incurring a high storage cost. It also implies either poor sales or excess inventory. It may also indicate poor liquidity, possible overstocking, and obsolescence.

High inventory ratio is a positive sign for the company and shows that it is able to sell its products on time which is resulting in lower or no storage cost and reflects better management of inventory by the company. It could also indicate shortage of inventories that may result in lesser sales.

Formula

There are two formulas to calculate inventory turnover ratio
a) Inventory turnover = Sales / Inventory
b) Inventory turnover = Cost of goods sold / Average inventory

Example
Assume sales of company = Rs. 50 crore and inventory = Rs. 25 crore
Inventory turnover = 50/25 = 2 times (2 inventory turns per year)
This means that a company would take 6 months to sell and replace all inventories. Average inventory is computed by taking inventory at the beginning and end of the period and then average it.