6.1 Calculation and Understanding of Accounting Ratios: Rate of Inventory Turnover (Times)

This section explains how to calculate and interpret the inventory turnover ratio, a crucial financial ratio that measures how efficiently a company is managing its inventory.

What is the Inventory Turnover Ratio?

The inventory turnover ratio indicates how many times a company has sold and replaced its inventory during a specific period (usually a year). A higher ratio generally suggests efficient inventory management.

Formula for Calculating Inventory Turnover Ratio

The formula for calculating the inventory turnover ratio is:

$$ \text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold (COGS)}}{\text{Average Inventory}} $$

Where:

• Cost of Goods Sold (COGS): The direct costs attributable to the production of the goods sold by a company. This includes the cost of materials, direct labor, and manufacturing overhead.
• Average Inventory: The average value of inventory held during the period. This is calculated by adding the opening and closing inventory balances and dividing by 2.

Calculating Average Inventory

To calculate the average inventory, you need the opening and closing inventory balances for the period.

$$ \text{Average Inventory} = \frac{\text{Opening Inventory} + \text{Closing Inventory}}{2} $$

Steps to Calculate the Inventory Turnover Ratio

1. Determine the Cost of Goods Sold (COGS) for the period. This information is usually found on the income statement.
2. Find the Opening Inventory balance at the beginning of the period. This is typically found on the balance sheet of the previous period.
3. Find the Closing Inventory balance at the end of the period. This is typically found on the balance sheet of the current period.
4. Calculate the Average Inventory using the formula: $$ \frac{\text{Opening Inventory} + \text{Closing Inventory}}{2} $$
5. Calculate the Inventory Turnover Ratio using the formula: $$ \frac{\text{COGS}}{\text{Average Inventory}} $$

Interpreting the Inventory Turnover Ratio

The interpretation of the inventory turnover ratio depends on the industry.

Generally:

• High Ratio (e.g., 5 or more): Indicates that the company is selling its inventory quickly and efficiently. This is usually a positive sign.
• Low Ratio (e.g., less than 3): Suggests that the company is not selling its inventory quickly. This could indicate overstocking, slow-moving products, or poor marketing.

Comparing the company's inventory turnover ratio to its competitors within the same industry is important for a meaningful analysis.

Example Calculation

Assume a company has the following information for the year:

• COGS = $80,000
• Opening Inventory = $10,000
• Closing Inventory = $15,000

1. Calculate Average Inventory: $$ \frac{10,000 + 15,000}{2} = $12,500 $$

2. Calculate Inventory Turnover Ratio: $$ \frac{80,000}{12,500} = 6.4 $$

Interpretation: The company has a high inventory turnover ratio of 6.4. This suggests that the company is selling its inventory 6.4 times during the year, indicating efficient inventory management.

Ratio	Formula	Interpretation
Inventory Turnover Ratio	$$ \frac{\text{COGS}}{\text{Average Inventory}} $$	Higher ratio indicates efficient inventory management; lower ratio suggests potential overstocking or slow sales.