Inventory Turnover Ratio = (Sales ÷ Inventory)
Inventory Turnover Ratio tells the analyst about how quickly a company is converting its inventory in to sales. This ratio gives a deep look into the inventory management skills of a company. Where you can view the capability of retaining inventory and making sales. In addition to above it can help you to reconsider the inventory holding policies for cost cutting.
To calculate Inventory Turnover ratio you can use ‘average inventory’ in the denominator. If you are using monthly sales in numerator then you must have to use average inventory of that month.
Inventory turnover ratio formula do not take account of fixed expenses. Moreover, it do not consider the cost of goods sold or any other debt involved in manufacturing process. But on the other hand cost of goods sold only focuses on certain variable expenses and do not account for other fixed costs.
For example: If a company sales are going lower and in turn decides to lower inventory for maintaining turnover ratio. But company may not be able to maintain the burden of debt with lower sales volume.
So, it is established thing that inventory turnover ratio only gives a limited view of a business. Moreover, it cannot replace liquidity ratio i.e. current ratio and it only serves a certain purpose in analysis.
Alternative to Standard Inventory Turnover Formula
There is also an alternative to standard inventory turnover ratio. Both are considered fine however, people use them respectively in different scenarios.
Inventory Turnover = (Cost of goods sold ÷ Inventory)
As it is apparent that this approach uses cost of goods sold method and it depicts the ability of a company to meet direct cost of selling products. As it do not take in to account the overall cost of business operations. It is worth saying that this approach is very helpful when comparing two companies.
Lets say, Company A and Company B are in same industry however, Company B has a higher gross profit. Both sell 5,000 units and cost of goods sold is same in both companies. However, Company B selling price is slightly higher than company A. If you calculate Inventory turnover ratio with SALES in numerator the ratio will be same. However Company B will have a lower turnover ratio if you use COGS in numerator.