What is the Inventory Ratio?
Inventory ratio comes under activity ratio and inventory ratio helps the company in knowing that how many times a certain company has to replace or sell the stock within a time frame and the same is calculated by dividing the average inventory from the total cost of goods sold.
It can be calculated by dividing the cost of goods soldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.read more by average inventoryAverage InventoryAverage Inventory is the mean of opening and closing inventory of a particular period. It helps the management to understand the inventory that a business needs to hold during its daily course of business.read more. In certain cases, sales are used instead of the cost of goods sold but that would unnecessarily distort the figure as sales include markup as well.
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For eg:
Source: Inventory Ratio (wallstreetmojo.com)
Examples of Inventory Ratio
Example #1
Kanchan jewelers have been operating since 1990 and have become one of the renowned jeweler’s shops in the town and also preferred by the customer. However, with the recent opening of Reliance Jewelers, the business of Kanchan jeweler seems to be much affected. Below are the sales data and its inventory for the past 3 years.
As can be seen, the sales are declining and inventory is rising which indicates intense competition and slow growth for Kanchan jewelers. Use Inventory Ratio to find out how much has been their business affected.
Solution:
First, we need to calculate the average inventory. Hence, for 2013 average inventory will be of 2012 and 2013, and similarly for 2014 will be an average of 2013 and 2014. Then in the second step, we can divide sales by average inventory.
Calculation of Inventory TurnoverCalculation Of Inventory TurnoverInventory Turnover Ratio is a measure to determine the efficiency of a Company concerning its overall inventory management. To calculate the ratio, divide the cost of goods sold by the gross inventory. read more for 2013 can be done as follows –
Calculation of Inventory Ratio for 2014 can be done as follows –
Analysis: We can see that in 2013 the ratio was close to 8 times and in 2014 it went down to 4 times which clearly shows that their inventory movement relative to sales have been halved and it is a clear sign of slow growth and intense competition from Reliance jewelers.
Example #2
Cutthroat competition limited has provided you the below details, and they have asked you to calculate the inventory ratio.
Solution:
The formula for calculating inventory ratio is the cost of goods sold divided by average inventory.
First, we will calculate the cost of goods sold.
- The formula for the cost of goods sold is Opening stock + Purchases – Closing stockClosing StockClosing stock or inventory is the amount that a company still has on its hand at the end of a financial period. It may include products getting processed or are produced but not sold. Raw materials, work in progress, and final goods are all included on a broad level.read more
- Cost of goods sold = 10,000 + 85,000 – 5,000 = 90,000.
Second, Average inventory can be calculated by dividing ( opening stockOpening StockOpening Stock is the initial quantity of goods held by an organization during the start of any financial year or accounting period. It is equal to the previous accounting period's closing stock, valued in accordance with appropriate accounting standards based on the nature of the business.read more + closing stock ) by 2
- Average inventory = (10,000 + 5,000) / 2 = 15,000 / 2 = 7,500.
In the final step, we will divide the cost of goods sold by average inventory
Inventory Turnover = 90,000 / 7,500 = 12 Times
Example #3
ABC limited and PQR limited both are competing and they are targeting their customers to choose their brand and avoid the other.
However, they have recently been questioned by the competition law tribunal for their intensive pricing the customer and the law tribunal feels that they are fooling the customer and they are sharing the areas where one dominates and other doesn’t and, in another area, the other dominates while the former doesn’t.
Below are the recent sales and inventory data available, you are required to calculate the turnover ratio and find whether any truth exists in the law tribunal’s statement?
Solution:
We can use a basic formula to calculate inventory ratio which is sales divided by average inventory.
Calculation of Inventory Ratio for ABC can be done as follows –
Calculation of Inventory Turnover for PQR can be done as follows –
The ratio of sales and average inventory appears to be similar and further the turnover ratio is quite close and therefore prima facie it appears that both the companies might be involved in an internal agreement but there are other various factors that should also be considered before coming to any conclusion.
Example #4
JBL limited whose business into selling Bluetooth speakers and other electronic devices is working out for loan proposals since they want to boost up their sales and are lacking funds to expand. VDFC bank has agreed to provide loan to JBL limited, and one of the conditions which are required to be fulfilled by them is their inventory turnover should be greater than 5 for the past 3 years.
JBL limited has provided below information for the past 4 years. You are required to advise whether they are fulfilling the bank condition?
Solution:
We can use a basic formula to calculate inventory turnover which is sales divided by average inventory.
Calculation of Inventory Ratio for 2014 can be done as follows –
Calculation of Inventory Turnover for 2015 can be done as follows –
In the recent year 2015, the company fails to pass on inventory ratio greater than 5 and there are high chances the company will face difficulties in getting the loan sanctioned.
Conclusion
Inventory turnover as discussed depicts how many times the firm has replaced and sold the stock or inventory during a given time. This ratio helps the firm or the businesses to make better decisions on whether being on manufacturing, purchasing new inventory, marketing, and pricing.
The low turnover ratio will imply weak turnover or weaker sales and possibly either stale inventory or excess inventory, and on another side, a higher ratio will imply either short on inventory or strong sales.
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This has been a guide to what is Inventory Ratio and its definition. Here we discuss inventory ratio formula along with practical examples and explanations. You can learn more about accounting from following articles –
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