Days Inventory Outstanding is an important key figure in inventory management. It indicates the period between the receipt of raw materials and the sale of the finished product. In this article we will show you why this indicator is important for cash flow management, how it is calculated and how it can be improved.
The Days Inventory Outstanding (DIO) ratio indicates the length of time a company's capital is tied up in its inventories. DIO is therefore important in liquidity management because the less capital is tied up in inventory, the more cash the company has available.
DIO can also be used to assess how well a product is selling and what the inventory efficiency is in general. If you calculate DIO for a single product, you look at the time from when the raw material is received to when the finished product is sold. So with DIO you measure the average storage time.
To calculate the Days Inventory Outstanding, one puts the average inventory in relation to the production and sales costs:
DIO = average inventory / cost of goods sold x 365
Multiplication by 365 indicates that the DIO value refers to the time span of one year. You can also multiply by another number, e.g. 90, if you want to look at the DIO value per quarter.
It is important that the period under consideration is always identical for both average inventory and cost of goods sold, otherwise you will get an incorrect value for DIO.
In the above formula, average inventory is the total value of inventory during the period under consideration. Costs of goods sold are all costs associated with the production and sale of the products.
A company has £30,000 worth of stock at the beginning of the year. At the end of the year it has £20,000 worth of stock. For all its products it has had production and selling costs of £200,000 during the year. Now we want to calculate the Days Inventory Outstanding. First we calculate average inventory:
Average inventory = (Beginning inventory + Ending inventory) / 2 = (£30,000 + £20,000) / 2 = £25,000
Now we can calculate DIO: DIO = £25,000 / £200,000 x 365 = 45,625 days
It therefore takes an average of 45,625 days for the finished products to be sold after receipt of the raw material.
In this way, DIO values can also be calculated for different products. Then the company can compare which products have less time in the warehouse until they are sold.
Do not confuse Days Inventory Outstanding with Inventory Turnover. The latter indicates how long it takes until the stock has been completely sold out and replenished with new stock. It is calculated like this:
Inventory Turnover = cost of goods sold / average inventory
For the example above, this results in: Inventory Turnover = £200,000 / £50,000 = 4
This means that the stock is completely turned over 4 times a year and the old stock is replaced by new stock.
The example above shows that a low Days Inventory Outstanding is advantageous because the faster a product leaves the warehouse, the faster the company generates revenue through sales.
If the DIO value is very high, it means that a lot of time elapses between the receipt of the raw material and the sale of the finished product. The company therefore has delayed revenues. However, because it has pre-financed the procurement of the raw material and also has to cover the production costs and all other costs, it has less cash available.
The DIO value is highly dependent on the industry in which a company operates. While DIO values are very low in food processing, they can be much higher in other industries (e.g. metal processing).
So if a company wants to find out whether its DIO value is OK, it should look at the values of other companies in the sector and compare itself with them. Non-industry comparisons are not useful for the DIO value.
If the Days Inventory Outstanding analysis shows that DIO is very high compared to competitors, the company should review its inventory. It is advisable to calculate a DIO value for each individual product. This will give an impression of which products are selling faster than others.
If a product lies in the warehouse for a very long time, this is an indicator that it is not selling very well. This analysis can therefore lead to strategic decisions: Is it still worth selling this product then?
By getting rid of poor-selling products, one can focus on those that sell well and possibly even make room for new products in the warehouse. A company can realign itself through DIO analysis and adjust its assortment to customer demand.
A sub-optimal warehousing strategy can also be the reason for a very high Days Inventory Outstanding value, e.g. if materials lie in the warehouse for a very long time until they are processed in production. In this case, procurement can be optimised by not purchasing materials at an early stage, but only when they can be supplied to production in a timely manner.