Learn On Your Own Accounting Entries For Inventory Turnover Ratio:

The inventory turnover ratio is an efficiency ratio that refers to the average number of times in an accounting period that a business sells and replenishes its inventory or stock of goods. The time taken or the period is divided by the inventory turnover formula to calculate the days taken to sell the inventory on hand or "inventory turnover days."

Inventory Turnover is calculated by dividing the for the year by the average closing inventory.

Inventory Turnover = Cost of Goods Sold / Average Inventory

Two components of the formula of inventory turnover ratio are :
  1. Cost of goods sold and
  2. Average inventory at cost.

Cost of goods sold = Opening Inventory + Cost of goods manufactured (purchases in case of trading company) - Closing Inventory.

Average inventory = Opening Balance of Inventory = Closing Balance of Inventory divided by two.

If cost of goods sold is unknown, the net sales figure can be used as numerator and if the opening balance of inventory is unknown, closing balance can be used as denominator. If both numerator and denominator are unknown, the formula would be written as follows:

Inventory Turnover Ratio = Sales / Inventory

Significance Of Inventory Turnover Ratio:

Inventory Turnover Ratio has great significance. A Low turnover reflects large investment in inventory and also indicates slow moving or obsolete inventories in stock; on the contrary a high turnover reflects low investment in inventory and also indicates fast moving inventories.

Inventory turnover ratio is also significant as because the total turnover of a concern depends on two main components of performance. The first component is stock. If larger amounts of inventory are purchased during the year, the company will have to increase its sale to match the greater amounts of inventory to improve its turnover. If the company can't increase its sale matching these greater amounts of inventory, it will incur higher warehousing or storage cost.

The second component is sales. Sales have to match inventory purchased otherwise the inventory will not turn effectively. That's why the purchasing and sales departments are like the two sides of a coin and must relate perfectly with each other.

Maintaining unnecessary excessive inventories indicates poor inventory management because it involves tiding up funds that could be used in other business operations.