Importance of Inventory Turnover Ratio for Control of Inventory and Purchases

One important method of exercising control over inventory is the application of ratio analysis to the inventory. In this context, inventory turn-over ratio is very important. Inventory turnover is a ratio of the value of materials consumed during a period to the average value of inventory during the period.

A high ratio indicates fast-moving stock. Inventory turnover may be indicated by the number of days in which the average inventory is consumed. This is done by dividing 365 days by the inventory turnover ratio. If the length of the inventory turnover period is short the material is said to be fast moving. The number of times an inventory is used within a particular period is a good measure of the efficiency of material utilization.

Thus knowing the turnover of different items it is possible to avoid keeping capital locked up in undesirable stocks. The following example will illustrate the point :

Example : From the following data of a Canadian Company for an accounting year calculate (a) material consumed, (b) average inventory held, (c) the inventory turnover and express the same in number of days the average is consumed for each material and comment on the purchasing procedure.

Material X and Y in Canadian Dollar. Opening Stock 1,000; Purchases during the year 5,200; Closing stock 600;

Thus material X is fast-moving and material Y is slow moving. Stock level of material Y may be re-fixed considering turnover ratio and purchases may be reduced on this item if the rate of consumption remains the same in the year to come.