What is the Inventory Ratio?

The inventory ratio comes under the activity ratio. The inventory ratio helps the company know how many times a certain company has to replace or sell the stock within a time frame. The same is calculated by dividing the average inventory from the total cost of goods sold.

It can be calculated by dividing the cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more by average inventoryAverage InventoryAverage Inventory is the mean of opening and closing inventory of a particular period. It helps the management to understand the inventory that a business needs to hold during its daily course of business.read more. In certain cases, sales are used instead of the cost of goods sold, which would unnecessarily distort the figure since sales include the markup.

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Examples of Inventory Ratio

Example #1

Kanchan Jewelers have been operating since 1990 and have become one of the renowned jeweler’s shops in the town and preferred by the customer. However, with the recent opening of Reliance Jewelers, the business of Kanchan Jewelers seems to be much affected. Below are the sales data and its inventory for the past three years.

As can be seen, the sales are declining, and inventory is rising, indicating intense competition and slow growth for Kanchan Jewelers. Use inventory ratio to find out how much their business has been affected.

Solution:

First, we need to calculate the average inventory. Hence, for 2013, the average inventory will be 2012 and 2013, and for 2014, it will be an average of 2013 and 2014. Then, in the second step, we can divide sales by average inventory.

Calculation of Inventory TurnoverCalculation Of Inventory TurnoverInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings.read more for 2013 can be done as follows:–

Calculation of Inventory Ratio for 2014 can be done as follows: –

Analysis: We can see that in 2013 the ratio was close to 8 times. In 2014, it went down to 4 times which clearly shows that their inventory movement relative to sales has been halved, and it is a clear sign of slow growth and intense competition from Reliance Jewelers.

Example #2

Cutthroat Competition Ltd. has provided you with the below details. In addition, they have asked you to calculate the inventory ratio.

Calculating the inventory ratio is the cost of goods sold divided by the average inventory.

Firstly, we will calculate the cost of goods sold.

The formula for the cost of goods sold =Opening stock + Purchases – Closing StockClosing StockClosing stock or inventory is the amount that a company still has on its hand at the end of a financial period. It may include products getting processed or are produced but not sold. Raw materials, work in progress, and final goods are all included on a broad level.read more

Cost of goods sold = 10,000 + 85,000 – 5,000

                                  = 90,000

Secondly, average inventory can be calculated by dividing ( Opening StockOpening StockOpening Stock is the initial quantity of goods held by an organization during the start of any financial year or accounting period. It is equal to the previous accounting period’s closing stock, valued in accordance with appropriate accounting standards based on the nature of the business.read more + closing stock) by 2.

Average inventory = (10,000 + 5,000) / 2

                                 = 15,000 / 2

                                 = 7,500

In the final step, we will divide the cost of goods sold by the average inventory

Inventory turnover = 90,000 / 7,500 = 12 times.

Example #3

ABC Ltd. and PQR Ltd. compete and target their customers to choose their brand and avoid the other.

However, they have recently been questioned by the competition law tribunal for their intensive pricing. The customer and the law tribunal feel they fool the customer and share the areas where one dominates and does not. In another place, the other dominates while the former does not.

Below are the recent sales and inventory data available; you must calculate the turnover ratio and find whether any truth exists in the law tribunal’s statement.

We can use a basic formula to calculate the inventory ratio: sales divided by average inventory.

Calculation of the inventory ratio for ABC Ltd. can be done as follows: –

Calculation of inventory turnover for PQR Ltd. can be done as follows: –

The ratio of sales and average inventory appears to be similar. Further, the turnover ratio is quite close, and therefore prima facie, it seems that both companies might be involved in an internal agreement. But one should also consider other various factors before coming to any conclusion.

Example #4

JBL Ltd., whose business sells Bluetooth speakers and other electronic devices, is working out loan proposals since they want to boost their sales and lack funds to expand. VDFC bank has agreed to provide a loan to JBL Ltd. One of the conditions they must fulfill is that their inventory turnover should be greater than 5 for the past three years.

JBL Ltd. has provided the below information for the past four years. Therefore, you must advise whether they are fulfilling the bank’s condition.

We can use a basic formula to calculate inventory turnover divided by average inventory.

Calculation of the inventory ratio for 2014 can be done as follows: –

Calculation of inventory turnover for 2015 can be done as follows: –

In the recent year, 2015, the company failed to pass on an inventory ratio greater than 5, and there is a high chance the company will face difficulties in getting the loan sanctioned.

Conclusion

As discussed, inventory turnover depicts how often the firm has replaced and sold the stock or inventory during a given time. This ratio helps the firm or the businesses make better decisions on manufacturing, purchasing new stockpiles, and even marketing and pricing.

The low turnover ratio will imply weak or weaker sales and possibly stale or excess inventory. On another side, a higher ratio indicates either a short inventory or strong sales.

This article has guided what inventory ratio is and its definition. Here, we discuss the inventory ratio formula and practical examples and explanations. You can learn more about accounting from the following articles: –

  • Cape RatioInventories ListInventory vs StockWork in Process Inventory