The inventory turnover ratio, also known as stock turnover ratio normally establishes the relationship between the cost of goods sold and average inventory. This ratio indicates whether an investment in inventory is within the proper limits or not.
The formula for the computation of this ratio may be expressed thus:
Inventory Turnover Ratio
= cost of goods sold/average inventory
In general, a high inventory turnover ratio is better than a low ratio. A high ratio implies good inventory management. A very high ratio indicates under-investment at a very low level of inventory which results in the firm being out of stock and incurring the high stock-out cost. A very low inventory turnover ratio is dangerous. It signifies excessive inventory or over-investment in inventory. A very low ratio may be the result of inferior quality goods, over-valuation of closing inventory, stock of unsaleable/obsolete goods.