Inventory Turnover Formula

Inventory is the stock of goods a company uses as raw materials for the process of production. So there is no doubt in the fact that purchasing inventory - the raw materials - is pretty much a certainty for the business to operate. There are two basic schools of thought governing inventory purchase. You can either purchase a high amount, fewer times over a year, avail the economies of scale and then store it in your warehouse. The disadvantage here is that the company will face warehousing costs, risks of spoilage and wastage and the risk of a fall in projected demand and therefore a loss. Alternatively, you can buy less amount, reduce the risk of loss but which means that you have to make your trip to the market more often. The inventory turnover is the financial management tool which helps the finance manager establish the way things stand presently and if there needs to be a change in the way the company is going about with its policy.

Explaining Inventory Turnover

The term inventory turnover goes by a number of names like inventory turns, stock turns, stock turnover, depending on which part of the world you live in. But the basic premise of the concept remains the same: to find out how many times the inventory 'turns over' within a specified period. The specified period is a year. Turning over means how many times it comes into the warehouse of the business and leaves it for the process of production. This ratio is calculated with the turnover formula in days which supplies the details regarding the stock turnover.

If the turnover ratio is high, which means that your policy involves buying more times over a period and consuming, there are a chain of events associated. Purchasing inventory involves two other costs other than the cost of purchase itself: the cost of holding the inventory (warehousing) and the cost of delivery. So if you buy less inventory, more times a year, then you incur a higher delivery cost for the period, because you have to go fetch the stuff a lot more times. At the same time, you need not have a pretty big warehouse and hence that cost is lower. Thirdly, having a low inventory means reduced risk of spoilage and wastage and that lesser company money is locked up in the process.

Purchasing more inventory means reduced aggregate delivery cost since the shipment perhaps comes only once or twice a year. Warehousing costs will be higher because there is a lot more stuff to store and hence needs a lot more space. And while there are chances of losses due to spoilage and the money is locked up, this can be compensated for by the benefits of economies of scale.

So the desired level of turnover really depends on the company policies. If the business uses a bulk of foreign made raw materials in its production, it makes little sense to order a tiny shipment every week or month. Then again, if the raw materials are like to be spoiled, then there is no option trying to store them for a longer time.

Obtaining the Formula

Calculate the cost of average inventory. If the period for which we are calculating the inventory turnover is a year, then average inventory can be calculated by the following formula.

Average Inventory = ^{Inventory at the Start of the Year + Inventory at the End of the Year}/₂

Once we've nailed that one, we go to the next step of calculating inventory turnover.

Inventory Turnover = ^{Cost of Goods Sold}/_{Average Inventory}

This is the base for a good bit of ratio analysis in managing the finances of the company. As is the case with most ratio analysis formulas, they tell you something about the finances of the company that perhaps cannot see with your naked eye.