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Inventory (or Stock) Turnover Ratio

This ratio indicates the number of times inventory is replaced during the year. It measures the relationship between the cost of goods sold and the inventory. The ratio may be computed in two ways. First, it is calculated dividing the cost of goods sold by the average inventory. Symbolically,

The average inventory figure may be of two types. In the first place, it may be the monthly inventory (stock) average. The monthly average can be found by adding the opening inventory of each month from, in case of the accounting year being a calendar year, January through January and dividing the total by thirteen. If the firm’s accounting year is other than a calendar year, say a financial year. (April to March), the average level of inventory can be computed by adding the opening inventory of each month from April through April and dividing the total by thirteen ? This approach has the advantage of being free from bias as it smooth an out the fluctuations in inventory level at different periods. This is particularly true of firms in seasonal industries. However, a serious limitation of this approach is that detailed month-wise information may present practice problems of collection for the analyst. Therefore, average inventory may be obtained by using another basis, namely, the average of the opening inventory and the closing inventory.

Not only are there difficulties in getting detailed information regarding inventory level, but data may also not be readily available to an analyst in respect of. the cost of goods sold. To solve the problem arising out of non-availability of the required data, the second approach to the computation of inventory turnover ratio is based on the relationship between sales and closing inventory. Thus, alternatively,

In theory, this approach is not a satisfactory basis as it is not logical. For one thing, the numerator (sales) and the denominator (inventory) are not strictly comparable as the former is expressed in terms of market price, the latter is based on cost. Secondly, the closing inventory figures are likely to be underestimates as firms traditionally have lower inventory at the end of the year. The net effect will be that the ratio given by this approach will be higher than the one given by the first approach. Thus the ratio has built-in bias to show better utilization of inventory.

In brief, of the two approaches to calculating the inventory turnover ratio, the first which relates the cost of goods sold to the average inventory is theoretically superior as it is logically consistent. The merit of the second approach is that it is free from practical problems of computation.