Inventory turnover ratio (ITR) is an activity ratio is a tool to evaluate the liquidity of inventory. It measures how many times a company has sold and replaced its inventory during a certain period of time.
Inventory turnover ratio is computed by dividing the cost of goods sold by average inventory at cost. The formula/equation is given below:
Two components of the formula of inventory turnover ratio are cost of goods sold and average inventory at cost. Cost of goods sold is equal to cost of goods manufactured (purchases for trading company) plus opening inventory less closing inventory. Average inventory is equal to opening balance of inventory plus closing balance of inventory divided by two.
Note for students: If cost of goods sold is unknown, the net sales figure can be used as numerator and if the opening balance of inventory is unknown, closing balance can be used as denominator. For example if both cost of goods sold and opening inventory are not given in the problem, the formula would be written as follows:
Inventory turnover ratio = Sales / Inventory
Compute the inventory turnover ratio and average selling period from the following data of a trading company:
$40,000* / $8,000**
Computation of cost of goods sold and average inventory:
*$75,000 – $35,000 = $40,000
**($9,000 + $7,000) / 2
Average selling period is computed by dividing 365 by inventory turnover ratio:
365 days / 5 times
The company will take 73 days to sell average inventory.
Significance and Interpretation:
Inventory turnover ratio vary significantly among industries. A high ratio indicates fast moving inventories and a low ratio, on the other hand, indicates slow moving or obsolete inventories in stock. A low ratio may also be the result of maintaining excessive inventories needlessly. Maintaining excessive inventories unnecessarily indicates poor inventory management because it involves tiding up funds that could have been used in other business operations.
Users must also observe various factors that can effect inventory turnover ratio (ITR) before interpreting or making any decision. For example, companies using FIFO cost flow assumption may have a higher ITR in the days of inflation because the latest inventory purchased at higher prices remain in the stock under FIFO. On the other hand, companies using LIFO cost flow assumption may have comparatively lower ITR than others because the oldest inventory purchased at comparatively lower prices remain in the stock under LIFO.
Another factor that could influence this ratio is the use of just-in-time inventory method. Companies using just in time system of inventory management usually have high inventory turnover ratio as compared to others in the industry.
The ITM trading company provides you the following data for the year 2016:
Inventory turnover ratio: 12 times
Opening inventory at cost: $36,000
Closing inventory at cost: $54,000
Calculate cost of goods sold for the year 2016.
Inventory turnover ratio = Cost of goods sold/Average inventory at cost
12 times = Cost of goods sold/$45,000*
Cost of goods sold = $45,000 × 12 times
*($36,000 + $54,000)/2