There are many ratios that can be used to assess how efficiently the resources of a business are being used by management. The three most frequently used efficiency ratios include Stock Turnover, Debtor Days and Creditor Days.
What does Stock Turnover measure?
Stock Turnover is also called Inventory Turnover. It shows the number of times a business sells its stock within one year. Therefore, with this ratio, managers can find out the speed at which a firm sells all its stock. And the speed it should replenish its inventories.
Stock Turnover can be expressed in two ways. Firstly, using the number of times per year all the inventories are sold out and need to be resupplied. Secondly, using the number of days it takes for the inventory of a business to be bought in and resold in a year.
In principle, the lower the amount of capital used in holding inventories, the better.
The lower the investment in inventories is, the higher Stock Turnover in the number of times per year, and the shorter Stock Turnover in the number of days. The higher the number of Stock Turnover in the number of times per year, the more efficient the managers are in selling inventory rapidly.
When comparing Stock Turnover, it is important to compare apples with apples, and oranges with oranges; meaning, comparing firms within the same industry.
The ‘normal’ result of Stock Turnover for a business depends on the industry it operates in. Different industries have very different benchmark figures for the average Stock Turnover ratio. Restaurants and suppliers of fresh food will have a significantly higher Stock Turnover than sellers of luxury jewelry, new cars and canned food. Also, these days, modern inventory-control systems help on minimizing investment in inventories.
Stock Turnover is only meaningful for companies selling goods. It is because companies providing only services, such as insurance companies or transportation companies, do not hold any inventories.
Stock Turnover measures the number of times a business sells its stock within one year. And, it also measures the speed at which a firm sells its stock.
How to calculate Stock Turnover?
There are two alternative ways to calculate Stock Turnover. The figures for working out Stock Turnover can be found in Profit and Loss Account (P&L Account) and Balance Sheet.
Firstly:
| Cost of Goods Sold (COGS) | |||
| Stock Turnover (Number of Times Per Year) = | ━━━━━━━━━━━━━━━━━━━━ | ||
| Inventories |
Secondly:
| Inventories | |||
| Stock Turnover (Number of Days) = | ━━━━━━━━━━━━━━━━━━━━ | x 365 | |
| Cost of Goods Sold (COGS) |
The data used in the formula for calculating Stock Turnover can come in three different ways:
- Using the average inventory holdings as at the start of the year and at the end.
- Using sales revenue instead of Cost of Goods Sold (COGS), if cost of sales data is not available.
- Using alternative formulae to measures the average number of days that money is tied up in inventories.
Comment
Stock Turnover is expressed in times per year as a number, and the number of full days.
When a business has Cost of Goods Sold (COGS) equal to USD$100,000 and an average stock level Inventories valued at USD$100,000, then Stock Turnover is 1, or every 365 days on average.
If Stock Turnover in number of times per year is 1, it means that a business bought inventory just once each year. Stock Turnover in days will be 365 days. Investment in inventories would be high to make sure that the business can last through the whole year.
This means that the business sells all of its inventory, which is then replenished, only once a year. This is not very frequent.
Stock Turnover (Number of Times Per Year):
- The higher Stock Turnover in times, the better because more products are sold, therefore the more efficient the business is in generating profit. A high Stock Turnover in times per year also means that perishable stock does not expire, or inventories do not become outdated.
- The lower Stock Turnover in times, the worse because less products are sold, therefore the less efficient the business is in generating profit. A low Stock Turnover in times per year also means that perishable stock may expire, or inventories become outdated.
Stock Turnover (Number of Days):
- The shorter Stock Turnover in days, the better because products are sold faster, therefore the more efficient the business is in generating profit. A shorter Stock Turnover in days also means that perishable stock does not expire, or inventories do not become outdated.
- The longer Stock Turnover in days, the worse because it takes longer time to sell products, therefore the less efficient the business is in generating profit. A longer Stock Turnover in days also means that perishable stock may expire, or inventories become outdated.
Example for Stock Turnover
COMPANY A
Company A has Cost of Goods Sold (COGS) of USD$1,000,000 and Inventories of $200,000 in 2020. In 2021, Company A has Cost of Goods Sold (COGS) of USD$1,500,000 and Inventories of $100,000 only.
| 2020 | 2021 | ||||||
|---|---|---|---|---|---|---|---|
| Cost of Goods Sold (COGS) | $1,000,000 | $1,500,000 | |||||
| Inventories | $20,000 | $100,000 | |||||
| Stock Turnover (Number of Times Per Year) | 5 | ➚ | 15 | ||||
| Stock Turnover (Number of Days) | 73 days | ➘ | 25 days |
Company A’s Stock Turnover increased from 5 times in 2020 to 15 times in 2021. This is the number of times inventory turns over in the time period – one year. So, Company A turned inventory over 15 times in 2021 comparing to 5 times in 2020. It means that the firm has more effective control over inventory management in 2021. It has lower level of inventories compared to Cost of Goods Sold (COGS) in 2021 than in 2020. Company A is also faster in selling products as it only takes 25 days in 2021 comparing to 73 days which it took in 2020.
How to improve Stock Turnover?
There are several ways that a business’s stock level can be reduced to improve its Stock Turnover:
- Conduct Inventory Audit. Get rid of old raw materials, any unfinished work-in-progress and obsolete finished goods which have not been sold for a long time.
- Hold less inventories. This requires holding lower stock levels in general which can be risky when the demand grows unexpectedly, or when a large order comes without prior notice. Proper forecasting of demand and Sales Forecasting may help.
- Replenish inventories more frequently. By introducing a Just-In-Time (JIT) stock management system inventory deliveries to the business would be more frequent, but smaller in size.
- Adjust Product Portfolio. This can be done by disposal of unpopular products in the firm’s portfolio or completely removing those products which sell slowly. Reducing the range of products being stocked will allow the business to keep only best-selling products.
- Sell products faster. Training current sales workers or hiring better sales personnel will speed up sales of products.
- Let customers pre-order products. By allowing customers to register for products in advance, inventory management will become more predictable, hence improved.
The efficiency position of a business can be enhanced by improving any of its efficiency ratios – increasing Stock Turnover, reducing Debtor Days and increasing Creditor Days.
