Analysis on inventory turnover ratio & holding level

MANU

CONVERSATION BETWEEN MANU AND VINU ABOUT INVENTORY TURNOVER RATIO & HOLDING LEVEL

VINU

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Manu

Hi Vinu!

Vinu

Manu! I am desperately waiting for you!

Manu

Why? What’s the matter?

Vinu

My Boss and his brother started business at same time.

Manu

Yes. I Know!

Vinu

They are into

• same line of business;
• same investment;
• same experience;
• same market;
•  same sales……..

Manu

Ya Ya…everything same…come to the issueyaar!

Vinu

Yes! When everything is same, why our Boss’s business is reports poor profits, whereas his brother is doing remarkably well with good profits?

Manu

Hmmm….there may be many reasons – let’s try to evaluate.

Vinu

Please help Manu.

Manu

The Problem can be identified to some extent by evaluating Turnover Ratios like Inventory Turnover and Receivables Turnover Ratios.

Vinu

Turnover Ratios?

Manu

Ya Vinu. Let us evaluate Inventory first - What’s the average inventory maintained by your Boss?

Vinu

He always maintains around Rs.25 Lakhs worth of Inventory.

Manu

Hmmm…that information alone will not help ….What is the cost of goods sold per annum?

Vinu

It is around Rs.50 Lakhs.

Manu

Then here lies the problem.

Vinu

What’s that?

Manu

Inventory turnover ratio is very low.

Vinu

How do you say that?

Manu

Look! Your one full year cost of goods sold is Rs.50 Lakhs and your Boss’s keeps around average inventory of Rs.25 Lakhs. It means, your inventories are not getting consumed or sold.

Vinu

It’s not clear.

Manu

Your inventory is getting rotated only twice in a year.

Understand the Key. Inventories are meant to be consumed / sold. It is only when inventory goes out of your business, you make profit.

If you keep inventories with yourself, it is going to incur only cost for you.

Vinu

Correct! With every sales, inventory comes down and profit goes up.

Manu

By keeping inventory with yourself, you are attracting lot many cost.

Vinu

Like?

Manu

You have to keep inventory in safe place, then you need people to take care of storage and management – all these will result in Storage Cost.

Vinu

Correct!

Manu

If you are investing money in Inventory, that money is not going to come back until those inventories are sold and cash is realised. But, you can’t afford to wait such long.

Vinu

Ya!

Manu

So, you have to arrange for alternate funds – either Bank funds like Cash Credit or Owners Funds.

Vinu

True!

Manu

These funds will not come free. They have a cost. It means, you have interest cost (bank loan) or opportunity cost (own funds) on the alternate funds.

Vinu

Very True!

Manu

So, if your inventory holding is very high, you will have high storage cost and opportunity cost. One relief with high inventory can be lower ordering cost.

Vinu

Ya! I remember all this – I have studied them in Cost Accounting – Economic Order Quantity

Manu

You are right. Let’s come back. In your case, your Boss keeps Inventory worth Rs.25 Lakhs, when cost of goods sold is Rs.50 Lakhs

Vinu

Ya!

Manu

It means Inventory Turnover Ratio is only 2 Times.

Vinu

How did you got that?

Manu

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Vinu

Ok

Manu

Here, Inventory Turnover Ratio =  50 L / 25 L = 2 Times

Vinu

Ya

Manu

It means your inventory is getting rotated only two times in a year.

Vinu

It means every six months?

Manu

Just imagine, you are going to wait for six months to sell your stock and wait for another six months to sell your next set of stock.

Vinu

Noooooooooooooo……

Manu

That’s what happening with your boss. He keeps stock equivalent to six months of cost of goods sold.

Vinu

But why?

Manu

Exactly. That’s my question. When he understands he can sell only for Rs.50 Lakhs per year, why he should keep inventory worth Rs.25 Lakhs. He should change his Inventory Policy.

Vinu

I am getting this.

Manu

Ideally, he should keep only 1 to 1 ½ Month level of inventory. This is just a thumb rule applicable for most of business (of course with some exceptions) and not based on empirical study.

Vinu

You mean to say, he should keep only around Rs.6.25 Lakhs worth of Inventory, if he is going to follow 1 ½ Months Inventory Policy.

Manu

Yes! You are right! If your annual cost of goods sold is Rs.50 Lakhs (for 12 months), then 1 1/12 months Inventory should work out to Rs.6.25 Lakhs (1.50x50/12)

Vinu

But what is the benefit?

Manu

Let’s see the benefit here.

By Changing your Inventory level from 25 Lakhs to 6.25 Lakhs, you release 18.75 Lakhs of locked investment back to your business. This will improve liquidity.

Vinu

Correct.

Manu

Your storage cost is going to come down as you don’t need such large space.

Vinu

True.

Manu

Your Interest cost on alternate funds are going to come down because your requirement for alternate funds have come down drastically to 6.25 Lakhs. You have pay, let’s assume, @ 14%.

For existing you should pay Rs.3.50 Lakhs but for the proposed level, your interest obligation is only Rs.87,500/- It is a huge saving.

Vinu

I agree.

Manu

So, this reduction in Storage Cost and Interest cost will reflect on your profit.

Vinu

But what about ordering cost?

Manu

Yes! There will be increase in ordering cost but it is not going to be that significant as it involves only clerical cost.

Vinu

OK.

Manu

So, understand, you can improve the profit of the business without increasing sales but just by altering your inventory holding.

Vinu

Now what will be the Inventory Turnover Ratio?

Manu

Let’s calculate that also

Vinu

Wow… Inventory Turnover Ratio improves to 8

Manu

Yes! So what you can infer is,

If Inventory T/O Ratio is low – it will result in liquidity issue and poor profit

Vinu

Correct! And if it is high, it will result in improved liquidity and Profitability

Manu

Exactly!

Vinu

Is it possible to calculate Inventory holding period using Inventory Turnover Ratio?

Manu

Yes Vinu!

Take Existing Case – inventory Turnover Ratio is 2 Times. Simple divide No. of days / months in a year by Inventory Turnover Ratio to arrive at Inventory Holding Period.

Vinu

Inventory Holding Period = No. of Months / Inventory Turnover Ratio

Inventory Holding Period = 12 / 2 = 6 Months

Manu

Good! And it tallies with our initial details!

Vinu

Yes! And for Proposed level,

Inventory Holding Period = No. of Months / Inventory Turnover Ratio

Inventory Holding Period = 12/8 = 1.50 Months

Hurraayyyyy!!!

Manu

Ha ha…This is just one aspect where you can do wonders in your profit without altering your Sales.

Vinu

So Receivables turnover ratio will also influence profits?

Manu

Yes! Very much! Ill explain that after some time :)

Vinu

Ok Manu! No Probs :)