Companies that sell goods typically maintain an inventory of raw materials, parts, work-in-progress (WIP) items, and finished goods as part of their operations.

The rate at which a business can convert its inventory into finished goods and sell them is a clear indicator of its ability to generate cash.

Hence, before a lender or investor finances a business, they need to know how many days it takes a business to convert inventory into a sale to understand how efficiently the firm handles its inventory.

This is measured by looking at the company’s days inventory outstanding.

Meaning

Days inventory outstanding is the average number of days a business stores inventory before it sells the same to its customers.

It is also referred to as days sales of inventory (DSI) and days in inventory (DII). It gives an indicator of the cost of holding goods and the duration for which inventory is held on average.

It shows how quickly a business can convert its inventory into cash and is also an insight into a company’s liquidity.

It is also used to check the financial and operational efficiency of a business. Another working capital metric to indicate the financial health of a business is days payable outstanding.

Formula of Days Inventory Outstanding

Days inventory outstanding (DIO) = (average inventory/cost of goods sold) x 365 Average inventory = (inventory in the beginning + inventory at the end of the year)/2

Example

Jonathan Pvt Limited sells wooden furniture. In the financial period of 2021, they recorded that their inventory at the beginning of the year was worth $20,000 and the end of the year at $40,000. with the cost of goods sold amounting to $600,000. This means that their average inventory is calculated to be $30,000.

To understand how long they held their inventory before selling it off to their customers, they calculated their days inventory outstanding. The calculation for this is: ($30,000/$600,000) x 365 = 18.25

Thus, Jonathan Pvt Limited can infer that it takes them approximately 18 days to convert their inventory into sales.

What Does Days Inventory Outstanding Tell Us

Days inventory outstanding is a ratio to evaluate a company’s inventory management efficiency.

It measures the number of days a company is in possession of its inventory before converting it into sales.

The lower the number of days taken, the lesser the period the cash is tied up in the stocks, and the lesser the risk of the company’s inventory becoming obsolete.

Should Days Inventory Outstanding be High or Low

Every company's DIO or days inventory outstanding can vary. It can be compared to the DIO of other companies in the same industry to understand how well a company's DIO is.

A high days inventory outstanding of a company indicates that it is not quickly turning its inventory into sales and can be interpreted as not being able to manage its inventory effectively.

A high DIO means that a business' cash is held up for a longer period, resulting in them being unable to reuse it for working on future orders and other growth activities.

It can also be associated with a company overstocking its inventory, leading to a high cost of holding and a higher risk of stock becoming obsolete and not being sold, which can also be an indicator of suboptimal inventory management.

When a company reports a low DIO, it is interpreted as inventory rapidly being turned to sales, indicating efficient working capital management and the cash being used for other purposes.

A low DIO also gives a sense of surety of stocks not becoming obsolete and being scraped off.

However, it may also mean a company would not be able to meet a sudden demand increase.

Improving Days Inventory Outstanding

A low days inventory outstanding is seen as more favorable than a high DIO. To reduce a company’s DIO, certain measures can be taken, such as -

  • Increasing the accuracy in predicting and planning to remove any gaps in the actual and forecasted sales. The more accurate a prediction, the lesser the need to keep a high level of stocks.

  • Deploying marketing strategies to increase demand for goods

  • Taking measures to ensure a speedy sales process to quickly convert inventory into cash.

  • Employing techniques to optimize stock levels

  • Disposing of slow-selling inventories by providing discounts

Inventory Turnover vs. Days Inventory Outstanding

Days inventory turnover measures how long a company holds inventory before converting it into sales. On the other hand, inventory turnover tells usthe number of times a company sells and restocks its inventory or goods in a given period.

In days inventory outstanding, a lower DIO is favorable, showcasing higher liquidity and enhanced working capital management.

On the other hand, a higher inventory turnover generally implies that a company is able to sell and replace its stock in a financial period continually and frequently. Hence, is considered to be a positive indicator.