This is a detailed guide on how to calculate Average Inventory Period with accurate interpretation, example, and analysis. You will learn how to use its formula to evaluate a firm's efficiency.
Definition - What is Average Inventory Period?
How many days on average a company holds its inventory before it turns it into sales is known as the average inventory period ratio, or days inventory outstanding (DIO) measure.
Typically the consensus of a good average inventory ratio result is the lower, the better as it suggests that the company can turn its inventory into sales and potential cash, quicker.
As well as this it means that the fresher, newer and thus more valuable stock is replacing the older inventory faster.
However, this measure is of more value when compared with previous results as well as other companies in the same industry.
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Formula
The formula to measure the average inventory in days is as follows:
Average Inventory Period Ratio = (Inventory / Cost of Sales) x 365
The average inventory processing period ratio can be arrived at by dividing a company’s Average Inventory by Cost of Sales and then multiply the result by 365 days.
In order to calculate the average inventory, you just need to sum the ending and beginning balance of a company’s inventory, and then divide the results by 2, like so:
Average Inventory = (Beginning Inventory + Closing Inventory) / 2
You can easily get all of these numbers reported on a company’s balance sheet and income statement.
Example
Okay now let’s take a look at an example so you can understand clearly how to calculate the average inventory in days.
Assume that you are considering to evaluate Company ABC, which sells luxury and premium vehicles.
Looking at its financial statements, you find that this company has an average inventory of $136,000. Its cost of sales totals $1,220,000.
To determine the average inventory period, we need to substitute into the formula:
So we have the average inventory days equal to 41 days. This suggests that the average length of time that the company holds onto its inventory before selling is 41 days.
Interpretation & Analysis
If the previous year average payment period of ABC Company were 55 days, then an average inventory period ratio of 41 days would suggest that the company is selling its inventory much quicker.
Converting inventory into cash faster would likely result in the company's cash flows being better which would be an excellent signal to any investors and creditors.
On the other hand, if the average processing period for the previous year was 35 days, this increase could be the main cause for concern as it would suggest the company is struggling to keep inventory liquid which in turn impacts the cash flow of the business.
There are many ways in which a company can encourage sales of its inventory and try and reduce its processing period.
These might include promotions or discounts for products that you need to sell faster.
So what is a good average inventory period?
Well, this depends on different industries. You will need to find out the average inventory days of several companies in the same industry.
Compare their average inventory period ratios to find out if the company you are evaluating is operating efficiently.
Cautions & Further Explanation
It is important to note that the industry the company operates in is of vital importance when judging the average inventory period ratio.
If a company sells perishable products such as food, they will, of course, expect to have a much lower processing time than a company selling non-perishables such as cars or airplanes
Therefore, it is vital to assess the company against others who sell the same or similar products and have a similar business model.
Looking at the simple example above we can see that ABC Company sells luxury and premium cars.
Being a slow moving, non-perishable industry, we would expect a higher inventory processing period in comparison to a supermarket chain.
