What it means
Inventory is cash in another form. Every unit sitting in a warehouse has been paid for, or will be paid for shortly, and produces nothing until it is sold.
A business that holds sixty days of inventory has two months of its cost of sales invested in stock; one that holds thirty days has one month, and the difference is cash that can be used elsewhere or borrowed less. Days inventory outstanding converts the balance sheet figure into a time measure that managers can understand and compare: it answers the question "how long does our stock sit here?" rather than "how much stock do we have?", and it scales naturally with the size of the business.
The calculation uses cost of goods sold rather than sales because inventory is carried at cost, and comparing a cost figure with a cost figure gives the right answer. Using sales in the denominator understates the days by the gross margin and makes the business look leaner than it is.
Average inventory, usually the mean of the opening and closing balances, smooths the effect of a single balance sheet date; a seasonal business should use monthly averages, because the year-end balance may be untypical. The reciprocal measure, inventory turnover, is cost of goods sold divided by average inventory; a turnover of six times a year is the same as about sixty days.
The right level of inventory days varies enormously by industry. A supermarket selling fresh food holds a few days; a fashion retailer a few months; a distributor of spare parts for industrial machinery may hold a year's worth because customers expect immediate availability of thousands of items.
A jeweller or a whisky distiller holds inventory for years by the nature of the product. The comparison that matters is with the company's own history and with direct competitors, and the question is always whether the inventory held is the inventory customers want.
High days can mean excellent availability or a warehouse full of unsaleable stock; the aggregate figure does not say which, and the analysis has to go beneath it. Going beneath it means calculating days by product category, by location and by age.
A distributor with sixty days overall may find that its fast-moving lines turn in five weeks and its slow lines in four months, and that the slow lines hold most of the cash. An ageing analysis shows how much inventory has not moved in 90, 180 or 365 days, which is the stock at risk of markdown or write-off.
Trend matters as much as level: inventory days rising while sales are flat means the business is buying more than it sells, and the consequence, whether a cash squeeze or a markdown, arrives later. Reducing inventory days is a matter of buying and making closer to demand: better forecasting, shorter supplier lead times, smaller and more frequent orders, open-to-buy controls that limit purchasing to what sales can absorb, and disciplined clearance of slow lines before they become dead stock.
The cash released is real, and the carrying cost avoided, which includes financing, warehousing, insurance, handling, shrinkage and obsolescence, typically runs at 15% to 25% of inventory value a year. The limit is service: cutting inventory below what customers require loses sales, and the lost margin can exceed the carrying cost saved.
In practice
Real-world examples.
Example
A supermarket chain holds inventory of $140,000,000 against cost of goods sold of $5,100,000,000, about 10 days, and its suppliers are paid on 45-day terms, so its inventory is sold long before it is paid for.
Example
A machinery parts distributor holds 180 days of inventory deliberately, because same-day availability is the reason customers pay its prices, and it prices that service into its margin.
Example
A furniture retailer's inventory days rise from 70 to 105 over a year while sales are flat, and the finance director traces it to a buying team that has continued ordering on last year's forecasts.
Think of it
“DIO shows how long products sit on shelves before selling-like measuring how long groceries stay in your refrigerator.
Formula
Calculation
Days inventory outstanding = Average inventory / Cost of goods sold x 365
Inventory turnover = Cost of goods sold / Average inventory
Days inventory outstanding = 365 / Inventory turnover
Cash conversion cycle = Days inventory outstanding + Days sales outstanding minus Days payable outstanding
Inventory required for a target = Target days / 365 x Cost of goods sold
Worked example. An electronics distributor had inventory of $9,000,000 at the start of the year and $11,000,000 at the end; cost of goods sold for the year was $60,000,000.
- Average inventory = ($9,000,000 + $11,000,000) / 2 = $10,000,000
- Days inventory outstanding = $10,000,000 / $60,000,000 x 365 = 60.8 days
- Inventory turnover = $60,000,000 / $10,000,000 = 6.0 times
- Using sales of $80,000,000 instead of cost would give $10,000,000 / $80,000,000 x 365 = 45.6 days, understating the true figure by a quarter
Target. Management sets a target of 45 days. Inventory required = 45 / 365 x $60,000,000 = about $7,400,000; cash released = $10,000,000 minus $7,400,000 = $2,600,000. At a carrying cost of 20% a year, the saving is about $520,000 a year, plus the interest on $2,600,000 of reduced borrowing.
Category analysis. Fast-moving lines: inventory $4,000,000, cost of goods sold $42,000,000, days = $4,000,000 / $42,000,000 x 365 = 34.8. Slow-moving lines: inventory $6,000,000, cost of goods sold $18,000,000, days = $6,000,000 / $18,000,000 x 365 = 121.7. The slow lines are 30% of the cost of sales but 60% of the inventory, and hold four months of stock. The target is reached by attacking the slow lines, not by cutting the fast lines that customers rely on.Case study
Seen in the real world.
A fashion retailer with cost of goods sold of $100,000,000 had run for years at about 95 days of inventory ($26,000,000), which the board accepted as normal for the sector. Over eighteen months the figure rose to 130 days ($35,600,000) while sales were flat. The buying team argued that the increase was investment in broader ranges; the finance director argued that it was unsold stock, and an ageing analysis settled the question: $9,000,000 of inventory was more than 180 days old, mostly from two seasons' ranges that had not sold through, and was sitting in a warehouse costing rent.
Clearing it was painful. The old stock was sold through outlet channels and a clearance partner at about 40% of cost, recovering $3,600,000 and crystallising a loss of $5,400,000, which had in truth been incurred when the ranges failed to sell but had been hidden in the balance sheet. The board then introduced open-to-buy controls that linked each season's purchasing commitments to the previous season's sell-through, cut the number of ranges, shortened the buying calendar so that later orders could be placed against early sales data, and made inventory days by range a monthly board measure.
Within a year inventory days were at 80 ($21,900,000), a reduction of $13,700,000 from the peak, of which $5,400,000 was the write-off and about $8,300,000 was cash actually released. The retailer used the cash to repay its revolving facility. The finance director's summary was that the inventory days figure had told the board the truth a year before the write-off, and that the cost of ignoring it was $5,400,000.
Watch out
Common mistakes.
- Using sales instead of cost of goods sold in the denominator, which understates inventory days by the gross margin percentage and flatters the business.
- Relying on the year-end balance for a seasonal business, when the balance at that date may be at its low or high point and the average over the year is very different.
- Reading the aggregate figure without breaking it down by category and age; a healthy overall number can hide dead stock in slow lines, and an unhealthy one can reflect a deliberate service policy.
Questions
People also ask.
What is a good number of inventory days?
It depends entirely on the industry: a few days for fresh food, one to two months for most distribution and manufacturing, several months for fashion and spare parts, years for spirits and jewellery. Compare with peers and with the company's own trend.
How does days inventory outstanding relate to the cash conversion cycle?
It is one of three components. Cash conversion cycle = inventory days + receivable days minus payable days, and it measures how long the business's cash is tied up between paying suppliers and collecting from customers.
Can inventory days be too low?
Yes. If stock is cut below what customers require, sales are lost, and the margin on lost sales can exceed the carrying cost saved. The right level balances availability against cost, and is set by service targets, not by the ratio alone.
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