Efficiency ratios - stock turnover ratio
This ratio measures a firm's success in converting stock into sales.
The ratio compares the value of stock with sales valued at cost. Stock is a specific and specialised asset. Why cost of sales? Stock is valued at 'cost or net realisable value'. To avoid inflating this ratio, we use cost of goods sold (cost of sales), without any profit margin. If the firm makes a profit on each sale, then the faster it sells it stock, the greater the profit it earns.
Too high a stock turn may indicate that a firm is selling out of stock and cannot match customer demand, which may lead to dissatisfaction and customers going elsewhere.
When examining this ratio it should be borne in mind that different companies will have varying levels of stock turnover depending on what they produce and the industry in which they operate. The figure varies hugely. A market trader selling fruit and vegetables may sell his stock every one or two days - approximately 110 times per year. A ship or plane manufacturer may have a much lower stock turn. Clearly though, the profit generated on a sale of a ship will be far higher than on an apple!
The first equation measures how many times in a period (usually the financial year) the firm turns over its stock. If you imagine a stock cupboard in the classroom full of products, then stock turn is the number of times the entire cupboard is sold.
The second equation shows the time it takes in days to turn over the total stock - or to the time taken to sell that stock cupboard. Firms only earn profit when they sell goods, so clearly the firm would want the lowest possible figure which would allow it to restock and sell again.
The ratio can be improved by holding less stock or by increasing sales. The firm may employ better stock control methods such as just-in-time production.
Problems arise from stock valuation itself. Are the items in stock really usable, or should they be written off? You must know the business, though, before you make comments about the level of stock. In some businesses the raw materials are seasonal, and can only be obtained once per year or the firm may buy in bulk to maximise discounts. Stocks then will average half a year's sales, and will seem excessive. There is nothing that can be done about it, unless the firm starts developing new sources of supply.
A supermarket, on the other hand, wants to get stocks in quickly, and then sell them fast. It does not want huge stocks, especially perishable products such as chilled foods.
|Company X ($k)||Company Y ($k)|
|Cost of sales||30,000||10,000|
|Stock turnover (days)||12.1 days||182.5 days|
|Stock turnover||x 30||x 2|