Stock turnover ratio indicates how frequently the stock of the company is used or gets converted into cash.  Stock turnover ratio is also known as inventory turnover ratio and is calculated by dividing cost of goods sold by average inventory (stock).

Calculation of Stock Turnover Ratio

Cost of goods sold is calculated with the help of following formula:

Opening Stock + Purchases + Direct Expenses – Closing Stock.

Average Stock is calculated with the help of following formula:

(Opening Stock + Closing Stock)/2

Let us understand the calculation of stock turnover ratio with the help of an example. Following figures are available for ABC Company.

Opening Stock: $ 15,000, Purchases: $ 1, 10, 000, Direct Expenses:  $ 10,000 and Closing Stock: $ 25,000

Cost of goods sold using above mentioned figures would be:

$ 15,000 (Opening Stock) + $ 1, 10, 000 (Purchases) + $ 10,000 (Direct Expenses) – $ 25,000
(Closing Stock) = $ 1, 10,000

Average stock would be: ($ 15,000 (Opening Stock) + $ 25,000 (Closing Stock))/2 = $ 20,000

Using cost of goods and average stock figures, we can calculate stock turnover ratio as follows:

$ 1, 10,000 (Cost of goods sold)/$ 20,000 (Average stock) = 5.5 times.

A company’s inventory comprises of raw materials, work in progress and finished goods. It is important for a company to maintain adequate quantity of raw material to ensure smooth running of the production process. At the same time, finished goods are sold to the customers from time to time. In case of any failure to convert raw material into finished goods and sale of finished to customers, a company may have to incur holding costs associated with storage and maintenance of inventory. Inventory turnover ratio helps in measuring a company’s ability in converting its raw material into finished goods and also its ability in converting its finished goods into sales.

A high inventory turnover ratio would result in lesser holding costs for a company.  A high turnover ratio may indicate effective conversion of inventory into sales by the company. It may also indicate that the inventory levels are kept at minimum levels by the company which can result in shortage of critical raw material required for production purposes. Such a situation can result in low production levels resulting in lesser amount of sales for the company.

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Let us understand the impact of increase in closing stock on the inventory turnover ratio. Considering the above example if closing stock increases to $ 55,000, inventory turnover ratio would reduce to 2.29 times as cost of goods sold would come down from $ 1, 10,000 to $ 80,000 and average stock would increase from $ 20,000 to $ 35,000.

A low inventory turnover ratio may indicate that the company is not efficient in converting its inventory into sales. It may indicate that either too much of raw material is kept in the warehouse or company is not able to sell its finished goods effectively. Such a situation may indicate an increase in holding costs for a company. Increase in holding costs may reduce the net profitability of the company.

It is important to note that a quick turnover of inventory also helps in preventing inventory items from getting obsolete which may have no saleable value in the near future. Interpretation of stock turnover ratio may vary from company to company and also from industry to industry. Figures required for calculation of inventory turnover ratio are easily available in a company’s financial statements.