The inventory/stock turnover ratio measures how quickly inventory is sold. It is a rest of efficient inventory management. To judge whether the ratio of a firm is satisfactory or not, it should be compared over a period of time on the basis of trend analysis. It can also be compared with the lever of other firms in that line of business as well as with industry average.
In general, a high inventory turnover ratio is better than a low ratio. A high ratio implies good inventory management. Yet a very high ratio calls for a careful analysis. It may be indicative of undernourishment in, or very low level of inventory. A very low level of inventory has serious implications. It will adversely affect the ability to meet customer demand as it may not cope with its requirements. Thus is, there is a danger of the firm being out of stock and incurring high stock out cost. It is also likely that the firm may be following a policy of replenishing its stock in too many small sizes. Apart from being costly, this policy may retard the production process as sufficient stock of materials may not be available.
Similarly, a very low inventory turnover ratio is dangerous. It significant excessive inventory or over investment in inventory. Carrying excessive inventory involves cost in terms of interest on funds locked up, rental of space, possible deterioration and so on. A low ratio may be the result of inferior quality goods, overvaluation of closing inventory, stock of unsaleable/obsolete goods and deliberate excessive purchases in anticipation of future increase in their prices and so on.
Thus, a firm should have neither too high nor too low inventory turnover. To avoid both stock out costs associated with a high ratio and the costs of carrying excessive inventory, with a low ratio what is suggested is a reasonable level of this ratio. The firm would be well advised to maintain a close,watch on the trend of the ratio and significant deviations on either side should be thoroughly investigated to locate the factors responsible for it. The computation of the turnover for the individual components of the inventory may be useful in this context. Such ratios can be computed in respect of raw materials and work-in-progress. Thus,