Study Notes: Business Finance & Accounting

Stock turnover

Stock turnover helps answer questions such as "have we got too much money tied up in inventory"?  An increasing stock turnover figure or one which is much larger than the "average" for an industry may indicate poor inventory management.

The stock turnover formula is:

Calculating stock turnover can be illustrated as follows

[note: assumes the inventories at year-end were equivalent to average stock during year]

From the data above, the business has improved its stock turnover, with the ratio rising from 8.6 times to 10.2 times per year.

As a general guide, the quicker a business turns over its stocks, the better.  But, it is more important to do that profitably rather than sell stocks at a low gross profit margin or worse at a loss.

Interpreting the stock turnover ratio needs to be done with some care.  For example:

• Some products and industries necessarily have very high levels of stock turnover.  Fast-food outlets turnover their stocks over several times each week, let alone 8-10 times per year! A distributor of industrial products might aim to turn stocks over 10—20 times per year
• Some businesses have to hold large quantities and value of stock to meet customer needs. They may have to stock a wide range of product types, brands, sizes and so on.
• Stock levels can vary during the year, often caused by seasonal demand.  Care needs to be taken in working out what the “average stock held” is – since that directly affects the stock turnover calculation

 A business can take a range of actions to improve its stock turnover:

• Sell-off or dispose of slow-moving or obsolete stocks
• Introduce lean production techniques to reduce stock holdings
• Rationalise the product range made or sold to reduce stock-holding requirements
• Negotiate sale or return arrangements with suppliers – so the stock is only paid for when a customer buys it

The last point to remember is that stock turnover is an irrelevant ratio for many businesses in the service sector.  Any business that provides personal or professional services, for example, is unlikely to carry significant stocks.