Inventory turnover and days’ sales in inventory (DSI) are two important financial ratios that measure how efficiently a company manages its inventory. Inventory is the stock of goods that a company has on hand for sale or for use in production. Managing inventory effectively is crucial for maintaining profitability and liquidity.
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What is Inventory Turnover?
Inventory turnover is a ratio that shows how many times a company sold or used its inventory during a given period, such as a year or a quarter. It can be calculated by dividing the cost of goods sold (COGS) by the average value of inventory during the period. COGS is the total cost of acquiring or producing the products that a company sells, and it includes the cost of raw materials, labor, and overhead. The average value of inventory is the sum of the beginning and ending inventory values divided by two.
The formula for inventory turnover is:
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A higher inventory turnover ratio indicates that a company is selling its inventory quickly and efficiently, which implies high demand, low holding costs, and minimal obsolescence risk. A lower inventory turnover ratio suggests that a company is holding too much inventory relative to its sales, which implies low demand, high holding costs, and increased obsolescence risk.
What is Days’ Sales in Inventory?
Days’ sales in inventory (DSI) is another ratio that measures how long it takes for a company to sell its inventory on average. It can be calculated by dividing the number of days in the period by the inventory turnover ratio. Alternatively, it can be calculated by dividing the average value of inventory by the COGS per day.
The formula for days’ sales in inventory is:
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or
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A lower days’ sales in inventory ratio indicates that a company is selling its inventory faster and more frequently, which implies high liquidity, low storage costs, and minimal spoilage risk. A higher days’ sales in inventory ratio suggests that a company is selling its inventory slower and less frequently, which implies low liquidity, high storage costs, and increased spoilage risk.
How are Inventory Turnover and Days’ Sales in Inventory Related?
Inventory turnover and days’ sales in inventory are inversely related, meaning that as one increases, the other decreases, and vice versa. This makes sense because if a company sells its inventory more often, it will have less inventory on hand at any given time, and vice versa.
The relationship between inventory turnover and days’ sales in inventory can be expressed mathematically as:
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For example, if a company has an annual inventory turnover of 10 and an annual days’ sales in inventory of 36.5, then:
10�����36.5=36510times36.5=365
This means that the company sells its entire inventory 10 times a year, or once every 36.5 days on average.
Why are Inventory Turnover and Days’ Sales in Inventory Important?
Inventory turnover and days’ sales in inventory are important indicators of a company’s operational efficiency, profitability, and liquidity. They can help investors, creditors, managers, and other stakeholders assess how well a company is managing its inventory and generating sales.
A high inventory turnover and a low days’ sales in inventory imply that a company has strong sales performance, low inventory costs, and high cash flow. This can enhance the company’s profitability and liquidity, as well as its ability to meet its short-term obligations and invest in growth opportunities.
A low inventory turnover and a high days’ sales in inventory imply that a company has weak sales performance, high inventory costs, and low cash flow. This can reduce the company’s profitability and liquidity, as well as its ability to meet its short-term obligations and invest in growth opportunities.
However, it is important to note that different industries have different norms and standards for inventory turnover and days’ sales in inventory. For example, a grocery store will have a much higher inventory turnover and a much lower days’ sales in inventory than an automobile manufacturer, because groceries are perishable goods that sell quickly, while automobiles are durable goods that sell slowly. Therefore, it is more meaningful to compare these ratios within the same industry or sector than across different industries or sectors.
Additionally, these ratios may be affected by various factors such as accounting policies, seasonal fluctuations, price changes, and inventory management strategies. For example, a company may use different methods to value its inventory, such as FIFO (first-in, first-out), LIFO (last-in, first-out), or weighted average cost. A company may also experience higher or lower sales and inventory levels during certain periods of the year, such as holidays or peak seasons. A company may also change its prices or offer discounts to stimulate sales or clear excess inventory. A company may also adopt different inventory management strategies, such as just-in-time (JIT), economic order quantity (EOQ), or safety stock. These factors may distort the comparison of inventory turnover and days’ sales in inventory over time or across companies.
Therefore, it is important to use these ratios with caution and in conjunction with other financial ratios and qualitative information to get a more comprehensive and accurate picture of a company’s performance and financial health.
Summary
Inventory turnover and days’ sales in inventory are two financial ratios that measure how efficiently a company manages its inventory. Inventory turnover shows how many times a company sold or used its inventory during a given period, while days’ sales in inventory shows how long it takes for a company to sell its inventory on average. These ratios are inversely related, meaning that as one increases, the other decreases, and vice versa. These ratios are important indicators of a company’s operational efficiency, profitability, and liquidity, but they should be used with caution and in conjunction with other financial ratios and qualitative information to get a more comprehensive and accurate picture of a company’s performance and financial health.
