Days Inventory Outstanding

What is Days Inventory Outstanding (DIO)?

Days inventory outstanding ratio simply speaks of the time a business takes to convert its inventory into sales. Also known as days sales of inventory, it is an important performance indicator in inventory and working capital management.

Days Inventory Outstanding Formula

The formula for DIO is simply expressed as follows:

Days Inventory Outstanding = (Average Inventory / Cost of Goods Sold) * 365

where,

  • Average inventory is the average inventory value at the beginning and the ending of the financial year.
  • The cost of goods sold is the same as represented in the income statement. It includes all the expenses relating to the production of goods and services sold.  It normally includes material, labor, and overheads.

Note that ‘sales’ is used at times for calculating this ratio due to difficulty in finding the right cost of goods sold for any reason. But it is not a right practice when inventory, i.e., our numerator, is valued at cost; the denominator should also be valued at cost.

The reciprocal of this ratio gives you an inventory turnover ratio, which is expressed in times rather than no. of days.

Days Inventory Outstanding Calculation with Example

Let’s take a small example and look at how we can calculate this metric.

Days Inventory Outstanding

Inventory value at the beginning = $40,000
Inventory value at the ending = $60,000
Cost of goods sold = $300,000
Days Inventory Outstanding = ($40,000 + $60,000) / 2 * 365 /  $300000 = 60 Days

Explanation of Days Inventory Outstanding

We can call 60 days as 2 months. From another angle of looking at it, we can also say that the frequency of replacing the inventory is 2 months. So, effectively, in the example, the firm is converting its inventory into sales 6 times a year (6 = 12 Months / 2 Months).
The figure of 60 days in the above example represents that the inventory that enters the entry gates of a firm will go out of exit gates in 60 days, becoming part of the finished goods of the firm. If the firm is a manufacturing concern, these 60 days would comprise the days of storing the raw material, processing the material on the production floor, staying in the stage of goods in process, finishing the goods in process, packaging, and dispatching.
In bookkeeping or accounting terms, the following process takes place. If we look at it, the inventory is created as an asset in the balance sheet on the date of receipt of the inventory, or it could be on the date of booking of the invoice in the accounting system.

Series of Events Dates Accounting Event
Purchase Order for raw materials is placed by the purchasing team 10 June  
The vendor accepts the order and raises the invoice 13 June Days of Inventory Begins or 
The vendor dispatches the raw materials from his factory
14 June
 
RM received at the factory & a goods inward receipt is prepared after proper verification of quality and quantity of goods with PO 20 June Days of Inventory Begins
Issued for Production 30 June  
Becomes a Goods in Process 25 July  
Becomes Finished Goods and Stored 30 July  
Sold to Customer and Dispatched 10 Aug Days of Inventory Ends

Interpretation of Days Inventory Outstanding and an Ideal Ratio

Lower is Better

The apparent interpretation of this metric is “Lower the Better.” Why is lower better?

Assume the firm in the example above has blocked the working capital of $20,000 in the inventories. Now, at the rate of 12% a year, the interest cost of holding the inventory would be $2,400. I have a simple question for you. Will the interest cost change if the company is able to reduce the inventory conversion cycle from 2 months to 1.5 months. No, because the interest cost is a fixed cost. It will neither change if the conversion time becomes 4 months nor when it becomes 1 month. Here is the real opportunity of taking advantage of financial leverage. When we know that interest costs will remain fixed, the management of the firm should focus on speeding up the inventory movement. That will directly show its positive impact on gross profits and consequently in net profits in the income statement.

Compare Only within Same Industries

Different companies may have different days sales of inventory. Can we say company A whose DIA is 60 days is better off than company B, with a DIA of 240 days?  The first instinct of anybody will say that company A is better off. In reality, we can’t judge by just looking at this metric alone. Along with this metric, we also should also first look at whether both the companies are in the same industry. Why should we do this?  There is a vast difference between the business operations in different industries. Let me introduce more information here. Company A trades in plywood, company B manufactures aircraft, and manufacturing time alone takes 200 days. Has your opinion changed? I believe ‘Yes.’ It has to. So, the first important thing is ‘When comparing DIO of 2 companies, they should exist in SAME INDUSTRY’.

Benefits

There are various benefits of this metric, and we will discuss them below:

Comparison tool for Investors

By now, you would agree that it can work as a great tool for investors when they are rating two companies on their efficiency in inventory management. We have already covered in detail what we should be careful about while comparing two companies.

Performance Indicator

The internal management can also use it as their tool or as a performance indicator for employees responsible for effective inventory management. When the appraisal of relevant employees is linked with this metric, they are bound to think, focus and bring positive change to the overall inventory processes.

Disadvantages of Days Inventory Outstanding

Like any other ratio, this ratio also has its own limitations. Let’s look at them.

Risk of Faulty Average Inventory

The real idea behind taking the average is to take an average inventory held by the company throughout the year. For the sake of ease, we take an average of opening and closing inventory for finding out this ratio. This thing creates a mess. Suppose a company has intentionally increased its inventory at the time of year, closing genuinely in expectation of a sudden big order. The figure of average inventory as per the stated formula will not represent a true average inventory of the firm in a real sense. One of the ways to overcome the problem of calculating average inventory is to take an average beginning inventory of 12 months. This, to a great extent, eliminates the problem of seasonality that we just discussed. Or we can also take the help of sophisticated ERP for this purpose for Greater accuracy.

DIO Alone is not Sufficient

This metric is not sufficient alone. By this, I mean you can’t say with confidence that a company’s inventory management is good or bad without comparing it with its peers in the same industry. Even after that, suppose a company is heavily investing in inventory because it has started catering to retail customers (where the orders are urgent) directly from the factory, which the other players in the sector are not doing. In this case, the extra margins earned by serving directly to retail markets compensate for the cost of holding inventory.

How to Improve Days Sales of Inventory Ratio?

A firm can see significant improvement in this ratio and achieve overall efficiency in managing its inventory by following the steps given below:

  • Accurate planning and forecasting of inventory can improve the ratio and ensure a smooth working capital cycle.
  • Increased sales with a better marketing strategy without a compensating increase in the investment in inventory can significantly improve the days of inventory outstanding.
  • Competitive pricing of the firm’s product can also boost sales if the product sales are price sensitive.
  • Lower the input prices with the help of techniques like negotiations with the vendor, bulk purchases, group purchases, etc
  • Working on the product mix of the firm and determining the top-selling products. Implement Pareto’s 80:20 Principle on the inventory to invest in the right inventory contributing maximum to the profits.
  • Focus on building an advance order book so that the planning of inventory becomes even more efficient.
  • With effective planning and forecasting, curb safety and dead inventory.
  • Optimize the level of stock with the help of techniques like EOQ, Just in Time, etc.

For an in-depth explanation, you can visit, How to Analyze and Improve Inventory Turnover Ratio?



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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