What is the Stock Turnover Ratio?
Stock turnover ratio is a relation between the stock or the inventory of a company and its cost of goods sold and calculates how many times an average stock is being converted into sales. When a company manufactures and sells its product, it incurs manufacturing cost which is registered as ’Cost of goods sold’. The amount of inventory that is consumed to manufacture the product and ultimately sell it is a crucial item for analysis.
Stock Turnover Ratio = Cost of Goods Sold/Average Inventory
Stock Turnover Ratio = Sales/Average inventory
It should be noted that both these formulae make similar inferences. However, there can be differences in numerical values, but the underlying consequences should be similar. Stock turnover is also called as inventory turnover, merchandise turnover or stock turn. These words may be used interchangeably to mean the same thing.
Examples of Stock Turnover Ratio
Calculate the stock turnover ratio for company X in the year 2018 if the inventory for FY 2017 and FY 2018 is $21,000 and $26,000. The cost of goods sold for the said year is $675,000. Data is in US dollars.
- Average inventory = (21000 + 26000)/2
- = 23500
- Stock turnover ratio = Cost of goods sold/Average inventory
- = 675,000/23500
- = 28.72
Inference: This ratio tells that company X turns its inventory roughly about 29 times to produce its cost of goods sold, and ultimately the sales for the company.
In the example above, we can also calculate Days in Inventory or DSI as it is known, by the following formula:
Days in Inventory = 365/Inventory turnover
- DSI = 365/28.72
- = 12.71.
Days in Inventory mean the number of days it takes for company X to convert its inventory into sales.
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
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 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 ratios are observed.
Advantages of Stock Turnover Ratio
- Stock turnover is a good measure of the working capital management of a company.
- This ratio can further be used to calculate Days in Inventory (as shown after Example 1) which is indicative of the number of days it takes to turn the inventory or stock into sales. This number is an inverse of inventory turnover.
- This analysis improves inventory management as it tells about the rapid or sluggish movement of stock being utilized to make sales.
- Stock turnover is a useful measure of managing holding costs. Optimal stock quantities optimize cash tied up in the working capital system.
- This ratio considers average inventory and hence, tells you the average turnover that produces sales. An average number can conceal important details. For instance, it does not clarify the weights of the different inventories.
- Not always does this ratio give a true picture of efficient inventory management. Quick turnover fails to attract discounts based on volume purchases.
- The stock turnover ratio must be viewed in conjunction with other financial and operational parameters. Any stock turnover ratio number is as good as its supporting measures.
Stock turnover ratio is a critical measure for a company and is widely used in financial analysis and financial modeling purposes, 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 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.
Important Points to Note
- The stock turnover ratio can be measured by both, Cost of goods sold and Sales. The inventory purchased should reflect in both these items. As the cost of goods sold should match the sales generated, inventory is a function of both these items.
- The formula says, ‘Average inventory’ and not just beginning or ending inventory. Let’s suppose a company purchased inventory worth $10,000 at the start of the year and sold it at the mid of the year. The year-ending inventory would not reflect $10,000 which is why average inventory is a better approach.
- Different stocks have liquidities to different degrees. Finished stock is more liquid than a work-in-progress inventory or an intermediate stock. This can be a vital measure for credit quality measurement of the company since the liquid stock can fetch cash quickly.
Stock turnover ratio is as much critical to inventory management as it is to the overall operations of a business. Due care should be taken when analyzing stock turnover.
- High turnover might also mean that the company is frequently purchasing which is why the cost per order is higher. It can also put the business in difficulty if prices from the suppliers’ end rise.
- A low turnover, among other things mentioned above, can be signaling toward inefficient working capital management. Another reason for low turnover can be lower sales which are not requiring the inventory to move quickly. Nevertheless, it can be a strategy of stock building knowingly.
This has been a guide to Stock Turnover Ratio and its meaning. Here we discuss how to interpret stock turnover ratio along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles –