How to calculate DIO
In order to calculate this financial ratio, you’ll first need to know the average inventory for an item and the cost of goods sold (also called the cost of sales). The average inventory is simply the sum of the inventory at the beginning of the period and the inventory at the end of the period divided by 2.
The cost of goods sold (COGS) are the expenses that can be directly connected to the production and sales of goods and services. This includes labor and materials that go into the production of the good or service, but not general business overheads.
Once we know these two numbers, we use the average days inventory outstanding formula, which is:
(Average inventory ÷ Cost of goods sold) x Number of days in the period
If the average inventory for the year was $35,000 and the cost of goods sold was $310,000, then the average inventory days outstanding would be:
($35,000 ÷ $310,000) x 365 days = 41.2
This means that it takes 41 days on average to turn inventory into cash. You can use this equation to compare DIOs for different products. If days sales of inventory are high, this can mean that inventory levels could be too high. When too much cash is tied up in inventory it will have a negative impact on cash flows.
Inventory turnover ratio and days inventory outstanding
Closely related to DSI is the inventory turnover ratio. The inventory turnover ratio is the number of times a business sells and restocks goods during a specified period. We use the inventory turnover formula to calculate it:
Inventory turnover ratio = cost of good sold during a period ÷ average inventory for that period
In our previous example, this would be $310,000 ÷ $35,000 = 8.86. This means that the inventory turns over 8.86 times per year. A higher inventory turnover ratio means that the inventory is moving faster. As with the DSI, the inventory turnover ratio can be used to compare different products.
Cash conversion cycle (CCC)
Days inventory outstanding is used to calculate another useful metric called the cash conversion cycle. The CCC (also called the net operating cycle or the cash cycle) shows the time (in days) it takes a company to convert what it has invested in inventory and other resources into cash flows from sales. The CCC measures how days funds are tied up in the production and sales process before cash is received.
The equation used to calculate the cash conversion cycle is:
CCC= Days of inventory outstanding + Days sales outstanding – Days payables outstanding
Days sales outstanding (also known as debtor days) is one variable that can be improved through better management of accounts receivable. Another option is to use inventory finance to get the cash needed.
A new way to get paid faster
Now that you understand the days inventory outstanding definition, what can you do to reduce the cash conversion cycle and improve working capital?
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