What is Stock Turnover Ratio?
The stock turnover ratio determines how soon an enterprise sells its goods and products and replace its inventories in a set duration. The stock turnover ratio formula is the cost of goods sold divided by average inventory. This ratio helps improve the inventory management as it tells about the speedy or sluggish flow of inventory being utilized to create sales.
Stock Turnover Ratio Formula
Stock Turnover Ratio Formula = Cost of Goods Sold /Average Inventory
Where,
- The cost of goods sold equals Opening stock + Purchases Less Closing Stock.
- The cost of goods sold can be replaced by the cost of sales as well.
- Average inventory is the mean of opening stock and closing stock. In case opening stock detail is not available, we can take closing stock as well.
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For eg:
Source: Stock Turnover Ratio (wallstreetmojo.com)
Steps to Calculate Stock Turnover Ratio
It can be calculated using the below steps:
- For a company, the cost of goods sold (i.e., COGS) is a yardstick for the production costs of services and goods. The cost of goods sold shall include the cost of labor costs, which are directly related to stock produced, materials, and any other fixed costs or factory overhead, which are directly used for producing those goods.
- The average stock needs to be computed as firms might carry lower or higher stock levels at a certain period during the year. E.g., Retailers such as Best Buy Co. Inc. might carry higher stock, which leads till the holidays in Quarter four and lower stock levels in Quarter one post those holidays.
- Dividing COGS by average stock will calculate the stock turnover ratio.
Examples
Let’s see some simple to advanced practical examples to understand it better.
Example #1
Suppose Company C had an average inventory during the year $1,145,678, and the cost of goods sold during the same period was $10,111,987. You have required to calculate the stock turnover ratio.
Solution
Use the following data –
- Cost of Goods Sold: 10111987.00
- Average Inventory: 1145678.00
- = 10,111,987 /1,145,678
- = 8.83 times
It means the stock rotates for 8 times.
Example #2
Sicco is a brand name for toothpaste in the country I. Company has taken a cash credit loan from Bank of Picco. The company is required to submit monthly stock and debtors’ details with aging on the same. Also, the company is required to submit a certain ratio, which includes the stock turnover ratio as well. The details from the company’s profit and loss statement are per below-
Based on the above details, you are required to calculate the Inventory Turnover Ratio.
Solution
In this example, we are given a profit and loss statement, and we need to figure out the cost of goods sold and average inventory as well.
Calculation of Cost of Goods Sold
Cost of Goods Sold=Opening Stock + Net Purchases – Closing Stock
= 3,500,000 + ( 21,350,000 – 320,250 ) – 4,200,000
- Cost of Goods Sold = 20,329,750
Calculation of Average Stock
Average Stock = ( Opening Stock + Closing Stock ) / 2
= ( 3,500,000 + 4,200,000 ) / 2
- Average Stock = 3,850,000
Calculation can be done as follows,
- =20329750.00/3850000.00
Stock Turnover Ratio will be –
- = 5.28 times
It means the stock rotates for 5.28 times.
Example #3
Company X is trying to evaluate 3 products that its currently selling in the market. It wants to analyze which one of the products is slow-moving and which one is the fast-moving good. On reviewing the detail of the three products, below is the summary created by the finance department.
| Particulars | Product 1 | Product 2 | Product 3 |
|---|---|---|---|
| Average Revenue Earned | 42000000.00 | 56000000.00 | 49000000.00 |
| Gross Profit Margin | 25.00% | 20.00% | 22.00% |
| Closing Stock | 5250000.00 | 5000000.00 | 6625000.00 |
Based on the above information, you are required to advise the management which goods are fast-moving and which is slow-moving?
Solution
In this example, we are given Average Revenue and closing stock. Since there is no opening stock information provided, we can take closing stock as a proxy for our computation purposes. Further, we are also not given purchases, and hence we cannot calculate the cost of goods sold with that formula. Still, instead, we are given a Gross profit margin, so if we deduct the gross profit margin from revenue, we will get the cost of sales, which we shall we use in the below formula.
Stock Turnover Ratio formula = Cost of goods sold or cost of sales /Average Inventory or Closing stock
Cost of Sales Margin For Product 1
=1-25.00%
- Cost of Sales Margin = 75.00%
Similarly, we can calculate the cost of sales margin for product 2 and 3
Cost of Sales
- =42000000.00*75.00%
- Cost of Sales = 31500000.00
Likewise, we can calculate the cost of sales for product 2 and 3
Calculation can be done as follows,
=31500000.00/5250000.00
- = 6.00
Similarly, we can calculate the stock turnover ratio for product 2 and 3
Using this ratio, it appears that product 2 is fast-moving as it has the highest turnover ratio and product 3 is comparatively slow-moving goods, which is 5.77 verses 6 for product 1. Further, the gross profit margin of product 1 is better than product 3; henceforth, it is a wise decision to chose to shut down product 3 if at all, the company is taking such a decision.
Walmart Stock Turnover Ratio
Walmart, the US retailer giant, is an example of the best inventory management system. Below is the Statement of financial position and Income statement for Walmart. What is the inventory turnover for the company?
Source: WalMart Annual Report
The cost of goods sold can be found out from the income statement above. And the average inventory can be calculated by taking the year-end inventories for FY 2019 and FY 2018.
Hence, Average inventory = Average of $44,269 and $43,783 = $44,026
Dividing Cost of goods sold by the average inventory,
We get a stock turnover of 8.75.
Inference: Walmart turned over its inventory 8.75 times in FY2019 to generate sales corresponding to the cost of goods sold, equating $385,301. A high turnover ratio is desirable for Walmart because of its retail business, where high inventory turnover ratiosTurnover RatiosTurnover Ratios are the efficiency ratios that measure how a business optimally utilizes its assets to generate sales from them. You can determine its formula as per the Turnover type, i.e., Inventory Turnover, Receivables Turnover, Capital Employed Turnover, Working Capital Turnover, Asset Turnover, & Accounts Payable Turnover. read more are observed.
How to Interpret Stock Turnover Ratio?
- The higher the stock turnover ratio, the better it is, and it means the company sells that product very quickly, and demand also exists for that product. It might also mean that the company is frequently purchasing. It can also put the business in difficulty if prices from the suppliers’ end rise. A higher ratio may also mean that the company is missing sales opportunities as it’s not carrying adequate stock.
- When the stock turnover is low, it would mean outdated inventory or slow-moving goods. It can be a signal toward inefficient working capital management. Nevertheless, it can be a strategy of stock building done knowingly.
Limitations
Stock turnover ratio is a critical measure for a company and is widely used in financial analysis; however, it has certain limitations;
- Stock turnover can not be relied upon completely to draw comparisons among peers without regard to certain similarities. A manufacturing business can find its inventory turning over at a slower pace than a restaurant business.
- A high turnover, which is, on the one hand, good for analysts, can have a discerning side when the firm sees more cash tied-up in the system than a low turnover operation.
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