Days' Inventory on Hand Ratio

Days' inventory on hand (also called days' sales in inventory or simply days of inventory) is an accounting ratio which measures the number of days a company takes to sell its average balance of inventory. It is also an estimate of the number of days for which the average balance of inventory will be sufficient. Days' sales in inventory ratio is very similar to inventory turnover ratio and both measure the efficiency of a business in managing its inventory.

Formula

Days' inventory on hand is usually calculated by dividing the number of days in a period by inventory turnover ratio for the period as shown in the following formula:

Days of Inventory = Number of Days in the Period
Inventory Turnover for the Period

Thus, if we have inventory turnover ratio for the year, we can calculate days' inventory on hand by dividing number of days in a year i.e. 365 by inventory turnover.

If we substitute inventory turnover as "cost of goods sold ÷ average inventory" in the above formula and simplify the equation, we get:

Days of Inventory = Average Inventory × Number of Days in the Period
Cost of Goods Sold

Analysis

Since inventory carrying costs take significant investment, a business must try to reduce the level of inventory. Lower level of inventory will result in lower days' inventory on hand ratio. Therefore lower values of this ratio are generally favorable and higher values are unfavorable.

However, inventory must be kept at safe level so that no sales are lost due to stock-outs. Thus low value of days of inventory ratio of a company which finds it difficult to satisfy demand is not favorable.

Days' sales in inventory varies significantly between different industries. For example, business which sell perishable goods such as fruits and vegetables have very low values of days' sales in inventory whereas companies selling non-perishable goods such as cars have high values of days of inventory.

Examples

Example 1: Company Y has inventory turnover ratio of 13.5 for the year. Calculate its days' inventory on hand ratio.

Solution
Number of days in the period = 365
Days' Inventory on Hand = 365 ÷ 13.5 ≈ 27

Example 2: Calculate the days' sales in inventory ratio using the information given below:

Beginning Inventory$213,000
Ending Inventory$265,000
Cost of Goods Sold (for the quarter)$5,712,000

Solution
Number of Days in the Period = 365.25/4 ≈ 91
Average Inventory = (213,000 + 265,000) ÷ 2 = $239,000
Days' Sales in Inventory = 239,000 ÷ 5,712,000 × 91 ≈ 3.8 days

Written by Irfanullah Jan