Inventory turnover ratio or stock turnover ratio is an indicator how many times inventory of a particular business is sold and being replaced by the new one during the exact period of time. In addition we also can calculate number of days (inventory turnover days), which will show how many days the business needs on average to sell inventory. To get these days, we divide number of days in the period (i.e. year) by Inventory Turnover Ratio.
The following formula is used to calculate this ratio:
Inventory Turnover=Sales / Inventory
Or other option
Inventory Turnover=Cost of Goods Sold / Average Inventory
The second inventory turnover formula better represents the results, as Cost of Goods Sold is compared with inventory, which is also at cost. Average inventory is better as it covers seasonal trends in inventory, if any. To calculate average inventory we should take inventory at the beginning and end of the period and divide by 2.
Inventory turnover ratio itself does not reflect anything. It should be compared with planned ratio, across different periods of time and with other companies in the same industry. Only in this way it will be possible to judge on whether this ratio is good or poor.
Usually in case stock turnover ratio is low, it would indicate that the business has too much inventory and is slow in selling it, which might lead to higher storage costs, more obsolete inventory on hand.
Too high ratio is also not very good indicator, since the business might sell inventory too quickly and not being able to buy sufficient inventory on time to satisfy the demand.
Generally higher inventory turnover ratio is preferred over lower, since higher level indicates that business quicker sells its inventory, i.e. shorter period of time is needed to generate sales with the certain level of inventory.