There are many financial ratios that are calculated by every company as they are a key factor to help understand the company about its performance and its financial standing. These are also used as a comparative factor to analyze your own company’s performance as compared to the others in the industry. There are many different kinds of financial ratios depending upon the type of information that you can get from these ratios and are divided into five main categories. Stock Turnover Ratio is one important financial ratio.
Stock Turnover Ratio also commonly known as inventory turnover ratio, is calculated to measure that how effective and efficient the firm is in managing its inventory. This ratio measures the total times for which the inventory has been sold and replaced in one financial year or in other words you can say that it is the indication that how frequent a company is in converting its stocks into cash in any financial year. The ratio is also a key indicator of the effectiveness of the organization to make use of its working capital which is stuck in the form of inventory.
Calculation of Stock Turnover Ratio:
There is a very simple formula devised by the financial analysts that could measure the stock turnover ratio. It is simply a relationship between the cost of goods sold and the average inventory. When the information is readily available, it is not difficult at all to calculate the ratio
The formula that could be used for calculating the ratio is:
Stock/Inventory Turnover Ratio Formula
The issue in calculating this ratio is that generally the information is not available in the financial statements i.e. in the balance sheet and in income statement which causes a great amount of difficulty for the analysts. So, for convenience, sales figure is used in place of cost of goods sold that in actual sense is wrong as the sales figures are based on the market price whereas the cost of good is the actual cost incurred in inventory hence, these two figures cannot replace each other.
The average inventory is calculated by taking the average of the opening inventory of all the months of the financial year. But, unfortunately, this data is also not easily available and hence for ease the average of opening and closing inventory of each year is used as a replacement.
Interpretation of Stock Turn Over Ratio:
As mentioned earlier, this ratio measures the number of times the inventory is replaced or sold. For example, if the ratio of the company is 4, then we can interpret it like that the company has sold its inventory 4 times a year or after every 3 months.
The Desirable Stock Turnover Ratio:
Like all the other aspects of the business, inventory also requires money and funds and generally the high ratio is desirable but, having too high or too low ratio is also not advised. The high turnover ratio on one side, is an indication that the company is effectively utilizing its inventory but at the same time shows that the company is not maintaining an adequate amount of inventory level meaning the company is placing the orders too frequently.
At the same time, it is obvious that the low stock turnover ratio is also harmful for the company as it indicates that the company’s purchasing system is not effective and the company is either buying too much stock or the sales are not as per the calculations. In either case, the risk of inventory aging increases, decreasing the value and chances of obsolescing of stock.
There are many factors that could distort the ratio. These include cost pools, overhead allocation, and standard costs as well. The stock turnover ratio should be analyzed with great care and according to the type of business you are running as every business has different stock needs and requirements. In case you have a low ratio, it could be improved with simple steps. You can either sell or dispose of the slow moving stock, lean production techniques could be utilized, the production and selling ranges should be accurately measured and the proper policies for return and sales should be followed.