Efficiency/Activity Ratios:

This ratio help the company with measuring the efficiency in asset management.Efficiency implies effective utilization of available resources.The term turnover refers to the rotation or utilization of a resource or an asset in the process of business activity.This ratio attempt to find out the efficient utilization of asset by relating the same to sale/cost of goods sold.It is a common knowledge that speedy disposal of finished goods stocks;effective use of working capital;quickcollection of sundry debtors and similar efficient operations have a positive and healthy impact on the success and the profit ability of the business.

Liquidity ratios(current ratio etc.) are the crude tests as they fail to throw any light on the efficiency in the use of working capital or its components.Therefore,turnover ratios should be supplemented along with the liquidity ratios to gain better understanding of the affairs of a business.

Important efficiency ratios helping in the analysis of liquidity are being discussed below.

 

Inventory/Stock Turnover Ratio:

This reatio helps to indicate the velocity with which stock of finished goods is sold i.e.replaced.It is expressed as number of times the average stock has been "turned over" or rotate of during the year.

(1). Blocking the scarce funds which could be gainfully employed elsewhere;

(2). Requiring more space resulting in higher maintenance and handling costs;

(3). May be the chance of product outdated or out of fasion especially in the case of consumer goods,

(4). During shortage for excessive period quality may deteriorate due to inherent factors like rusting loss of potency etc.Similarly insufficient level of inventory is also dangerous because it may be responsible for the loss of business opportunity.Thus for each item of stock minimum average and maximum levels should be fixed carefully.Inventory ratio should,Preferably calculated as:

 

                       Inventory Turnover Ratio= Cost of Cood Sold               

                                                                 Ave Inventory at Cost 

Where

        Cost of Good Sold= Sales-Gross Profit+Gross Loss

or

       Opening Stock+Net Purchases+Direct Exp.-Closing Stock

and

       Average Inventory=Opening Stock+Closing Stock

                                                                    2

However in the absence of requied information any one of the following formula can be used:

                                                            Inventory Turnover Ratio=Net sales                                                            

                                                                                Average Inventory at Cost

or

=Net Sales  

     Inventory

or

=Net sales

 Ave. Inventory at selling price

 

Interpretation:

High turnover suggests efficient inventory control,sound sales policies,trading in quality goods,reputation in the market,better competitive capacity.

Low turnover suggest the possibility of stock comprising of obsolete items,slow moving products,poor selling policy,over investment in stock.

 

Inventory Conversion Period:

For better understanding it is of interest to know that an average how many days were taken to dispose off average inventory?It is known as inventory conversion period and is calculated as:

 

Inventory Conversion Period=     Days in the Years

                                                         Inventory Turnover Ratio

 

or

 

=No. of days in the year* Ave inventory at cost

                                                 cost of goods sold

 

Example:

Calculation of Inventory Turnover Ratio and Inventory conversion period?

 

Cost of goods sold                                                                       4,50,000

Opening Stock                                                                             1,25,000 

Closing Stock                                                                               1,75,000

 

Solution:

 

(1).Inventory Turnover Ratio:

                                                                          =Cost of goods sold

                                                                             Average Inventory

  

                                                                          =    4,50,000             

                                                                              (1,25,000+1,75,000)/2

 

                                                                         = 4,50,000

                                                                             1,50,000

 

                                                                        = 3 times

 

(2). Inventory Conversion Period:

                                                                       =Number of days in the year

                                                                          Inventory Turnover ratio

                                                           

                                                                      =  365        =121.66 days=122 approx. days

                                                                             3

 

 

 

Alternative :

                                                                          = 365* Average Inventory

                                                                               Cost of good sold

 

                                                                          = 365*(1,25,000+1,75,000)/2

                                                                                              4,50,000

 

                                                                         = 365* 1,50,000            =121.66 days=122 approx. day

                                                                                   4,50,000