10.2 Analysis of Published Accounts – Financial Efficiency Ratios
Rate of Inventory Turnover: Calculation and Interpretation
📦 What is Inventory Turnover? It tells us how many times a company sells and replaces its inventory during a period. Think of it as a speedometer for stock – the faster it goes, the more efficiently the business is using its goods.
Step‑by‑Step Calculation
- Find Cost of Goods Sold (COGS) – the total cost of items sold in the period.
- Calculate Average Inventory:
- Opening Inventory (beginning of period)
- Closing Inventory (end of period)
- Average = \$\frac{Opening\ Inventory + Closing\ Inventory}{2}\$
- Apply the formula:
\$Inventory\ Turnover = \frac{COGS}{Average\ Inventory}\$
Illustrative Example
Suppose a retailer has:
- Opening Inventory: £50,000
- Closing Inventory: £30,000
- COGS for the year: £200,000
Average Inventory = \$\frac{£50,000 + £30,000}{2} = £40,000\$
Inventory Turnover = \$\frac{£200,000}{£40,000} = 5\$
| Item | Amount (£) |
|---|
| Opening Inventory | 50,000 |
| Closing Inventory | 30,000 |
| Average Inventory | 40,000 |
| COGS | 200,000 |
| Inventory Turnover | 5 |
Interpretation
🔄 A turnover of 5 means the retailer sold and replenished its stock five times a year. Generally:
- Higher turnover (e.g., 8–10) suggests strong sales or efficient inventory management.
- Lower turnover (e.g., 2–3) may indicate overstocking, slow sales, or poor demand forecasting.
Remember, the “ideal” number varies by industry – fast‑moving consumer goods usually have higher ratios than heavy manufacturing.
Exam Tip Box
📝 Exam Tip: When calculating inventory turnover:
- Always use average inventory – not just the closing figure.
- Check the units: COGS and inventory should be in the same currency.
- Look for clues about seasonality – a retailer might have a higher turnover in the holiday season.
- Explain the business implication: a high ratio can mean good cash flow but also risk of stockouts; a low ratio can mean excess stock and tied-up capital.
Good luck! 🚀