What is stock turnover ratio (STR)?

The stock turnover ratio (STR) is a financial metric that measures how often a company's inventory is sold and replaced over a specific period. Two different approaches to calculating the stock turnover ratio exist, each focusing on different aspects of inventory management.

How is STR measured?

Below are the two different ways of measuring and calculating STR:

  1. Stock Turnover Ratio (Focused on Cost of Goods Sold (COGS) / Average Inventory)
    • Focus: This ratio, sometimes referred to as Inventory Turnover Ratio, focuses on the relationship between the cost of goods sold and the inventory levels maintained by the company. It indicates how efficiently a company manages its inventory concerning the cost of goods sold. A higher ratio indicates that the company sells inventory more frequently, which can signify efficient inventory management.
    • Formula: The stock turnover ratio is calculated using the Cost of Goods Sold (COGS). The Average Inventory is determined by dividing the COGS by the average inventory level during the period under consideration. The formula is:
      COGS = Beginning Inventory + Inventory Purchases During the Period - Ending Inventory
      Stock Turnover Ratio = COGS / Average Inventory
    • Example: Example: Let's consider a retail company that sells electronic goods. They want to evaluate their inventory management efficiency and identify opportunities for improvement. The company calculates the STR using the formula COGS / Average Inventory. They find their COGS for the year is $1,000,000, and their average inventory level over the same period is $250,000. The STR of 4 indicates that, on average, the company sells and replaces its inventory four times during the year. This suggests a relatively high turnover rate and efficient inventory management.
  2. Stock Turnover Ratio (Focused on Value Used in the Past 12 Months / Value Held Today)
    • Focus: This ratio compares the value of goods sold or used in the past 12 months to the current value of inventory held by the company. It provides insights into the usage rate of inventory over the past year and how it compares to the inventory level at a specific time. It tells you if you have over-invested in stock and indicates if you have the right inventory mix. It directly relates your inventory level to the demand level for that inventory.
    • Formula: The stock turnover ratio calculated using Value Used in the Past 12 Months and Value Held Today is determined by dividing the total value of goods used or sold in the past 12 months by the total value of current inventory. The formula is:
      Stock Turnover Ratio = Value Used in the Past 12 Months / Value Held Today
    • Example: If a company holds $5M of inventory today and has issued $2.5M of inventory in the past year, the STR is 0.5 (it has turned over its inventory investment at the rate of one-half per year). A world-class STR is 2.5. It would help if you noted that the stock turnover is a ratio versus a percentage. This is because the units for the figures used in the calculation are different. The value used in the past 12 months is in dollars per year, and the value held today is in dollars. That’s why the value of the above example is 0.5, not 50%.

How do I use the different STR approaches?

Stock Turnover Ratio (Focused on Cost of Goods Sold (COGS) / Average Inventory)

You can use this ratio calculation to set benchmarks against industry averages or competitors to assess your performance relative to others. This allows your team to determine whether they are above or below industry standards and identify areas for improvement if necessary.

For example, your company can set realistic inventory turnover targets based on this ratio and the benchmarks. You may aim to increase your ratio to 5 or 6 to improve efficiency further. By tracking the ratio over time and adjusting inventory levels, you can optimize their stock levels to align with customer demand and minimize carrying costs.

The ratio can also help identify slow-moving or excess stock. If the ratio is low compared to industry benchmarks, it may indicate that certain items are selling slower than expected. This can prompt the company to reassess, offer discounts or promotions, or adjust procurement decisions to prevent overstocking.

Stock Turnover Ratio (Focused on Value Used in the Past 12 Months / Value Held Today)

You can use STR to determine how to spend your inventory budget better. Stock turn ratio can help you investigate your investment in spare parts and spot operational inefficiencies in purchasing, tracking, and using inventory. For example, a stock turn ratio of 0.5 is low, yet typical, and indicates an overstocked plant, especially if stock outs are also low.

If stock outs are high and the STR is low, a facility is probably investing in inventory that isn’t being used while lacking in-demand stock. STR targets are influenced by several controllable and uncontrollable issues, such as inventory purchasing processes and the facility's location.

Benefits of measuring and tracking STR by approach

Below are some of the benefits of monitoring STR by each specific approach:

  1. Stock Turnover Ratio (Focused on Cost of Goods Sold (COGS) / Average Inventory)
    • Efficient inventory management: By using this formula, businesses can assess how well they manage their inventory and how quickly they turn over or sell their stock. A higher stock turnover ratio indicates that the company sells inventory more frequently, thereby signaling efficient inventory management.
    • Working capital management: A high stock turnover ratio can result in lower carrying costs and less money tied up in inventory, which can improve overall working capital management. This, in turn, can free up capital for other business needs or investments.
    • Comparison and benchmarking:This ratio allows businesses to compare their performance to industry benchmarks or historical data and track trends over time. Benchmarking against industry peers can provide insights into how well a company is performing relative to its competitors regarding inventory management.
  2. Stock Turnover Ratio (Focused on Value Used in the Past 12 Months / Value Held Today)
    • Optimized inventory levels: Maintenance teams can better manage their inventory levels by monitoring the stock turnover ratio. They can avoid overstocking or understocking, which can lead to wasted resources or production delays. Maintaining the right inventory level ensures that necessary spare parts and equipment are always available when needed.
    • Cost reduction: Maintaining excess inventory ties up capital and incurs storage costs. By optimizing stock turnover, maintenance teams can reduce carrying costs and minimize the risk of obsolescence or deterioration of spare parts. This, in turn, leads to cost savings for the organization.
    • Enhanced maintenance planning: Knowing the rate at which spare parts and equipment are used allows maintenance teams to plan their maintenance schedules more effectively. They can schedule maintenance activities to coincide with stock replenishments, reducing downtime and optimizing maintenance resources.

Common challenges when using STR by approach

There are several common challenges when using and interpreting the stock turn ratio, below are some for each approach:

  1. Stock Turnover Ratio (Focused on Cost of Goods Sold (COGS) / Average Inventory)
    • Different inventory holding periods: The stock turnover ratio assumes a uniform inventory holding period throughout the year. However, if a business experiences fast-changing trends, it may have shorter holding periods, which can affect the accuracy of the calculated ratio and make forecasting difficult.
    • Inaccurate inventory valuation: Errors in recording or tracking inventory value can lead to an inaccurate ratio and misinterpretation of inventory turnover.
    • Inclusion of non-selling costs: The COGS used in the calculation may include non-selling costs like overhead expenses or admin costs. These costs can distort the ratio and provide a misleading view of inventory turnover.
  2. Stock Turnover Ratio (Focused on Value Used in the Past 12 Months / Value Held Today)
    • Excluding specific inventory: A stock turn ratio must be applied across the entire inventory. It’s not accurate if only a certain inventory is selected. That’s because some inventory items will have a high turnover while others will be low, so it’s necessary to consider everything. The ratio aims to measure the overall efficiency of inventory investment.
    • Using incorrect data: The stock turn ratio shows the effectiveness of the investment in spare parts over a year, so the calculation should be based on the value used in the past 12 months. However, a common mistake is to base the calculation on the value purchased. Depending upon where a company is in the spare parts stocking cycle, the two values of used versus purchased inventory could be significantly different. This then results in a misleading stock turn ratio.
    • Misinterpreting the ratio: A common mistake is interpreting the calculation as a percentage vs a ratio. Using the example above with a stock turn of 0.5, 10% of the inventory value has moved five times, and the other 90% has never moved. If a percentage is used, it would imply that 50% of the items have moved when this is not the case.

Stock turnover ratio evaluates an organization's inventory

Whether you're using the COGS formula or value used, the stock turnover ratio provides insight into whether the funds allocated to inventory drive results or lie dormant. Organizations can identify operational improvement opportunities by understanding how STR is measured and interpreted. Moreover, recognizing common pitfalls in utilizing STR can lead to more accurate and insightful analysis. Mastering the intricacies of STR ensures a streamlined inventory system and promotes sustainable financial health for an organization.

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