Cambridge IGCSE Accounting(0452)/O Level Principles of Accounts(7110) Notes: Introduction to Liquidity Ratios: Rate of inventory turnover

- Proprietors often want to know how “well” their business is doing
- Besides such measures as profitability
- one way of estimating liquidity is through the rate of inventory turnover ratio
- The ratio estimates the number of times inventory is sold or used in a given financial period for example a trading year
- This ratio gives the approximate number of times a given entity has bought and sold its entire stock
- Consider the simple example of a banana vendor
- She goes to a warehouse and purchases $50 in banana stock
- It takes her three days to sell this stock and
- Only after she sells the entire stock does she return to purchase another batch of bananas worth $50
- During this period we say she has an inventory turnover of 1
- That is she only turned her purchases into sales once during the three day period
- Now imagine she does the same thing over a period of one month with roughly the same sales
- Her rate of stock/inventory turnover would be 30 days divided by the three day period it takes her to make one turn
- i.e.
**10** - What this means is that on average we expect her to turn her stock of bananas into sales 10 times each month
- Traditionally the ratio was called the rate of stock turn
- It measured how quickly a business turns purchased items into sales
- Now that tends to preclude manufacturing businesses from the discussion
- To prevent this the term inventory has now supplanted the word stock
- This includes manufacturing businesses as they use up raw materials turning them into finished goods
- In manufacturing businesses the ratio thus measures the amount of times an entity uses up stock of raw materials and turns them into finished goods

#### Calculating inventory turnover ratio

- In real world businesses it would be unwise for the business to wait until it has run out of inventory in order to order new inventory
- This would result in lost sales and lost production
- To prevent this most businesses, unlike the banana vendor example above, tend to order more inventory to replenish what they have
- Usually each business has a certain minimum level of stock which when reached means new inventory has to be ordered
- This somewhat complicates the calculation of rate of inventory turnover
- The most accepted method for calculating this is:
- \mathrm{ \dfrac{Cost\quad of \quad Sales}{Average\quad Inventory}}
- Average inventory (stock) is calculated as:
- \mathrm{ \dfrac{Inventory \quad at \quad the \quad Beginning + Inventory \quad at \quad end}{2}}
- For example stock was $450 at the beginning and closing stock was $350 and purchases were $5 000 during a given period
- To calculate the rate of inventory turnover we have to calculate Average Inventory First
- This would be:
- \mathrm{ \dfrac{450+ 350}{2}}
**400**- Cost of Sales would be
- 450+5 000-350
**5100**- The rate of inventory turnover would thus be:
- \mathrm{ \dfrac{5100}{400}}
**12.75 times**- i.e. The business in question cycled through inventory just under 13 times

NB In examination/exercise questions where either inventory (stock) figure is missing just use the available figure e.g Opening or Closing Stock whichever is available. Also in the first year of trading only the closing stock is available. Just use this instead.

#### Expressing inventory turnover in days

- Instead of saying how many times in a given period a business cycles through inventory it might be useful to express the same concept in days, weeks, months etc
- For example it takes business A 7 days to completely turnover its inventory from purchases to sales
- It takes business B 1 month to complete one cycle etc
- The formula for this is:
- \mathrm{ \dfrac{365 days}{Rate \quad of \quad inventory \quad turnover}}
- For example in the above example:
- \mathrm{ \dfrac{365}{12.75}}
**28.63 days**- That is it takes about 29 days for the business to go through one inventory turnover cycle

#### Meaning of the ratio

- A higher rate of inventory turnover is desirable as it means a business is quickly turning inventory into sales
- A slowing rate means sales are slowing
- The rate of inventory turnover might also be used as a rudimentary measure of liquidity
- A high rate of turnover implies the business is liquid and can quickly pay its creditors when so called upon
- A low rate of of inventory turnover means a business might struggle to raise working capital to meet its short term obligations

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