How is Inventory Turnover Ratio calculated and what is Holding Level | ApnaCourse

by | May 27, 2016 | Financial Management

MANU

CONVERSATION BETWEEN

VINU

1

MANU AND VINU

 ABOUT INVENTORY TURNOVER RATIO & HOLDING LEVEL

  2

Manu Hi Vinu!
Vinu Manu! I am desperately waiting for you!
Manu Why? What’s the matter?
Vinu My Boss and his brother started business at same time.
Manu Yes, I Know!
Vinu They are into
·         Same line of business;
·         Same investment;
·         Same experience;
·         Same market;
·         Same sales …
Manu Ya …. Everything same ….. come to the issue yaar!
Vinu Yes! When everything is same, why our Boss’s business is reports poor profits, whereas his brother is doing remarkably well with good profits?
Manu Hmmm… there may be many reasons – let’s try to evaluate.
Vinu Please help Manu.
Manu The problem can be identified to some extent by evaluating Turnover Ratios like inventory Turnover and Receivables Turnover Ratios.
Vinu Turnover Ratios?
Manu Ya Vinu. Let us evaluate inventory first – what’s the average inventory maintained by your boss?
Vinu He always maintains around Rs. 25 Lakhs worth of inventory.
Manu Hmmm… that information alone will not help …. What is the cost of goods sold per annum?
Vinu It is around Rs. 50 Lakhs.
Manu Then here lies the problem.
Vinu What’s that?
Manu Inventory turnover ratio is very low.
Vinu How do you say that?
Manu Look! Your one full year cost of goods sold is Rs. 50 Lakhs and your Boss’s keeps around average inventory of Rs. 25 Lakhs. It means, your inventories are not getting consumed or sold.
Vinu It’s not clear.
Manu Your inventory is getting rotated only twice in a year.

Understand the Key.  Inventories are meant to be consumed / sold it is only when inventory goes out of your business, you make profit.

If you keep inventories with yourself, it is going to incur only cost for you

Vinu Correct! With every sales, inventory comes down and profit goes up.
Manu By keeping inventory with yourself, you are attracting lot many cost.
Vinu Like?
Manu You have to keep inventory in safe place, then you need people to take care of storage and management – all these will result in Storage Cost.
Vinu Correct!
Manu If you are investing money in inventory, that money is not going to come back until those inventories are sold and cash is realized. But, you can’t afford to wait such long.
Vinu Ya!
Manu So, you have to arrange for alternate funds-either Bank funds like Cash Credit or Owners Funds.
Vinu True!
Manu These funds will not come free.  They have a cost.  It means, you have interest cost (bank loan) or opportunity cost (own funds) on the alternate funds.
Vinu Very True!
Manu So, if your inventory holding is very high, you will have high storage cost and opportunity cost.  One relief with high inventory can be lower ordering cost.
Vinu Ya! I remember all this – I have studied them in Cost Accounting – Economic Order Quantity.
Manu You are right.  Let’s come back.  In your case, your Boss keeps inventory worth Rs. 25 Lakhs, when cost of goods sold is Rs. 50 Lakhs.
Vinu Ya!
Manu It means inventory Turnover Ratio is only 2 Times.
Vinu How did you get that?
Manu Inventory Turnover Ratio = Cost of Goods sold / Average inventory
Vinu Ok
Manu Here, Inventory Turnover Ratio = 50 L / 25 L = 2 Times
Vinu Ya
Manu It means your inventory is getting rotated only two times in a year.
Vinu It means every six months?
Manu Just imagine, you are going to wait for six months to sell your stock and wait for another six months to sell your next set of stock.
Vinu Nooooooooooooo………
Manu That’s what happening with your boss.  He keeps stock equivalent to six months of stock of goods sold
Vinu But why?
Manu Exactly.  That’s my question.  When he understands he can sell only for Rs. 50 Lakhs per year, why he should keep inventory worth Rs. 25 Lakhs.  He should change his inventory policy.
Vinu I am getting this.
Manu Ideally, he should keep only 1 to 1.5 Month level of inventory.  This is just a thumb rule applicable for most of business (of course with some exceptions) and not based on empirical study.
Vinu You mean to say, he should keep only around Rs. 6.25 Lakhs worth of inventory, if he is going to follow 1.5 Months inventory policy.
Manu Yes! You are right! If your annual cost of goods sold is Rs. 50 Lakhs (for 12 months), then 1.5 months inventory should work out to Rs. 6.25 Lakhs (1.50x50/12)
Vinu But what is the benefit?
Manu Let’s see the benefit here

Particulars Existing Proposed Change
i) inventory 25 Lakhs 6.25 Lakhs 18.75 Lakhs
ii) Storage cost 50,000.00 12,500.00 37,500.00
iii) interest cost @ 14% 3,50,000.00 87,500.00 2,62,500.00
iv) Total cost (ii+iii) 4,50,000.00 1,00,000.00 3,00,000.00

By changing your inventory level from 25 Lakhs to 6.25 Lakhs, you release 18.75 Lakhs of locked investment back to your business.  This will improve liquidity.

Vinu Correct.
Manu Your storage cost is going to come down as you don’t need such large space.
Vinu True.
Manu Your Interest cost on alternate funds are going to come down because your requirement for alternate funds have come down drastically to 6.25 Lakhs.  You have to pay, let’s assume, @ 14%.  For existing you should pay Rs. 3.50 Lakhs but for the proposed level, your interest obligation is only Rs. 87,500/- It is a huge saving.
Vinu I agree.
Manu So, this reduction in Storage Cost and Interest cost will reflect on your profit.
Vinu But what about ordering cost?
Manu Yes! There will be increase in ordering cost but it is not going to be that significant as it involves only clerical cost.
Vinu Now what will be the Inventory Turnover Ratio?
Manu Let’s calculate that also

Particulars Existing Proposed
i) cost of goods sold 50 Lakhs 50 Lakhs
ii) Inventory 25 Lakhs 6.25 Lakhs
iii) Inventory Turnover Ratio (i/ii) 2 Times 8 times
Vinu Wow… Inventory Turnover Ratio improves to 8
Manu Yes! So what you can infer is,
·         If inventory T/O Ratio is low – it will result in liquidity issue and poor profit
Vinu Correct! And if it is high, it will result in improved liquidity and profitability
Manu Exactly!
Vinu Is it possible to calculate inventory holding period using Inventory Turnover Ratio?
Manu Yes Vinu!
Take Existing case – inventory Turnover ratio is 2 Times.  Simple divide No. of days / months in a year by inventory Turnover Ratio to arrive at Inventory Holding Period.
Vinu Inventory Holding Period = No. of Months / Inventory Turnover Ratio

Inventory Holding Period = 12 / 2 = 6 Months

Manu Good! And it tallies with our initial details!
Vinu Yes! And for proposed level.

Inventory Holding Period = No. of Months / Inventory Turnover Ratio
Inventory Holding Period = 12 / 8 = 1.50 Months

Huraayyyy!!!

Manu Ha ha … This is just one aspect where you can do wonders in your profit without altering your sales.
Vinu So Receivables turnover ratio will also influence profits?
Manu Yes! Very much! I’ll explain that after sometime
Vinu Ok Manu! No Probs
N Raja CA, A Practicing Chartered Accountant with tonnes of passion for teaching. He also holds a PGDBA – Finance from Symbiosis SCDL and a B.Com., from Loyola College, Chennai. Read More.

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