Businesses are run by sales. Days inventory outstanding is a measure that tells how quickly a business is turning its inventory into sales.
Days inventory outstanding (DIO) is an important working capital ratio. It also shows the operating efficiency and short-term liquidity positions of a company.
Let us discuss what is a DIO ratio, how we can calculate it, and what important information it offers.
Days Inventory Outstanding (DIO) – Definition
Days inventory outstanding means time taken by a company to turn its inventory into sales. It is also knowns as days sales in inventory or inventory days.
DIO is an important working capital ratio that tells us about the operational efficiency of a business. An efficient business will convert its inventory into finished goods quickly. That in turn will reduce the inventory holding period and accelerate the cash cycle.
DIO is calculated using average figures of inventory, cost of goods sold (or cost of sales), and the number of days in the accounting period. Usually, an annual figure of 365 days and average figures for the same annual accounting period are used in the DIO calculations.
Days inventory outstanding is closely linked with inventory turnover ratio. The DIO figure tells us how long a company takes to complete an inventory turnover and the inventory turnover is the number of times a company utilizes its inventory.
How Days Inventory Outstanding Works?
Days inventory outstanding (DIO) tells us about converting raw materials into sales. It’s an important part of the cash conversion cycle of a business.
We need the following information to determine the DIO of a company:
- Accounting period length for which the DIO is required.
- Average inventory figure that can be calculated by adding new purchases to beginning inventory and deducting ending inventory.
- The average cost of goods sold or the cost of sales for the same accounting period.
Then, we can use these figures in the formula to calculate the DIO figure.
Formula
Days Inventory Outstanding = (Average inventory / Cost of sales) x Number of days in the period
Average inventory = (Beginning inventory + ending inventory)/2
Cost of sales or cost of goods sold can be used from the income statement figures.
Number of days is the accounting period that is usually 365 days.
A company must ensure to use the correct inventory figures. Matching the inventory levels with the accounting records is important. An inventory audit or a regular audit can be conducted to verify these figures.
Also, a company must use the relevant cost of goods sold that directly relate to the inventory costs. For clarity, a company can separate labor and overhead costs from the inventory costs to get accurate inventory figures.
How to Calculate Days Inventory Outstanding?
A step-by-step calculation of days inventory outstanding is an easy approach that offers accurate figures and detailed analysis.
STEP 01:
The first step is to calculate the average inventory figure that is the numerator of the DOI formula. Average inventory can be calculated by adding the beginning and ending inventory figure and dividing the sum by two.
Both inventory figures should relate to the same accounting period.
STEP 02:
Cost of sales or cost of goods sold can be calculated by using the beginning inventory figure. Add the new purchases and relevant inventory costs to that amount.
Remember, you should only include costs relevant to inventory here. For example, include only direct labor, direct material, and other direct inventory costs.
Deduct the ending inventory figure from the sum obtained and you’ll get the cost of goods sold.
STEP 03:
The third step is to simply decide the accounting period. Most companies use an annual period and use 365 days in the DIO formula.
A company can use periodic lengths such as 90 days for quarterly calculations as well. However, care must be taken to include relevant inventory, COGS, and cost of sales figures for the same accounting period.
STEP 04:
The final step is to put the calculated figures into the DIO formula.
First, you should divide the average inventory by the cost of goods sold figure calculated. Second, multiply the resulting figure above with the number of days of the accounting period you chose in step 03.
The resulting figure will give you the days inventory outstanding for the accounting period.
Examples of Days Inventory Outstanding
Suppose a company ABC has an average inventory balance of $7,000 for its current accounting period. The cost of goods sold for the company is $80,000 for the same period.
The company uses an annual or 365 days as the accounting period for its calculations.
We can calculate the Days Inventory Outstanding (DIO) for ABC Company using the formula:
Days Inventory Outstanding = (Average inventory / Cost of sales) x Number of days in the period
Days Inventory Outstanding = ($7,000/$80,000) × 365 = 31.93 days
Suppose company ABC had an average inventory of $ 3,000 and the cost of goods sold of $ 50,000 for the previous accounting period.
Its days inventory outstanding for the previous accounting period were:
Days Inventory Outstanding = (Average inventory / Cost of sales) x Number of days in the period
Days Inventory Outstanding = ($3,000/$50,000) × 365 = 21.9 days
ABC Company can use the calculated figures to analyze issues with its inventory management, operating efficiency, and sales efforts to maximize profits.
Importance of Days Inventory Outstanding
Days inventory outstanding (DIO) is an important figure in the cash conversion cycle of a business. It means the figure plays a crucial role in determining the cash conversion cycle. Usually, the shorter the cash conversion cycle the better it is for a business.
DIO is also an important metric when analyzed as a standalone figure. It can reveal operating deficiencies for a business. A company can increase operating efficiency to reduce its DIO ratio.
Since the DIO figure uses average inventory and the COGS figures, supplier relations and credit terms also affect the DIO figure. If a company maintains a healthy DIO, it shows an impressive operating efficiency and good credit terms with its suppliers and vendors.
Interpretation of Days Inventory Outstanding
Days inventory outstanding is an important working capital management ratio. It is directly linked with the operating efficiency of a business. It can reveal important information about the short-term liquidity of a business as well.
It is important to interpret the calculated results from a DIO figure carefully.
High DIO
A high DIO figure simply means a company is taking longer to convert its inventory into cash. The longer the period the higher the DIO ratio.
It is important to keep in mind that most companies buy inventory in bulk to avail discounts from suppliers. It means the average inventory figure can fluctuate during the accounting period.
Also, a company must consider the factors affecting the days inventory outstanding. For instance, does the external economic conditions slow down the sales of a company that compels a company to keep inventory for long?
Low DIO
A low DIO figure is usually preferred by all businesses. It means a company is quickly converting its inventory into sales and receiving cash faster.
Generally, a quicker DIO also means a company has an efficient operating capacity. Thus, a low DIO is usually liked by all businesses.
It’s important to mention here that DIO ratios for different companies within the same industry should be compared. Also, the size and nature of production should be similar when analyzing DIO figures.
Days Inventory Outstanding Vs Inventory Turnover Ratio
Days inventory outstanding and inventory turnover ratios can be linked closely.
Inventory turnover ratio is the number of times a company converts its inventory into cash in an accounting period. Whereas, days inventory outstanding is the number of days a company takes to complete one turnover cycle.
Both ratios directly relate to the working capital management and operating efficiency of a business.
A high inventory turnover ratio is good for a business. A higher inventory turnover means a company is utilizing its resources efficiently. A quick turnover means a company can convert more inventory into sales thus maximizing its profit potential.
Contrarily, a low days inventory outstanding is preferred by a business. Essentially, it also means a company takes fewer days to convert inventory into sales.
Analyzing both figures can help a company understand its working capital and operating capacity requirements. It can then use these figures to set its marketing, pricing, and credit policies.
Another important aspect of inventory management is to synchronize the sales and procurement departments of a business. Efficient and improved DIO and turnover ratios mean both the sales and purchases departments are closely linked and following the company policies efficiently.
