How effective is your company at turning its inventory into cash?
If you’re like many business leaders, you probably don’t have a clear answer to this question. We’re going to help you change that by introducing you to a metric known as days inventory outstanding.
In this article, we’ll dive into what days inventory outstanding is, why it's important to understand, measure, and track, and how to improve yours.
What is days inventory outstanding (DIO)?
Days inventory outstanding — regularly abbreviated as DIO — is a financial metric that measures the average number of days it takes your company to sell its entire inventory.
It answers the question:
What is the average number of days we hold onto inventory before selling it?
DIO is part of a group of metrics that help you assess your company’s operational efficiency, particularly as it relates to liquidity and the management of working capital.
Working capital — the difference between your current assets and current liabilities — is crucial for day-to-day operations. Effective management of working capital involves optimizing how quickly you can turn these assets into cash to pay down your liabilities.
Days inventory outstanding is one of three core metrics that business leaders use to measure this efficiency. The two others are:
- DSO — Days Sales Outstanding
- DPO — Days Payable Outstanding
The DIO metric looks at how quickly your business turns over its inventory. A lower DIO means you turn inventory over more quickly and vice versa. Lower DIOs are generally preferable, as they indicate that the business is adept at freeing up capital for other operational needs, such as meeting debt repayment obligations or investing in growth initiatives.
Why DIO is important for business
There are four big reasons why it’s important to keep an eye on your company’s DIO:
- Cash flow management. Minimizing the time that inventory sits on shelves helps improve cash flow and increases liquidity.
- Operational efficiency. A low DIO is also a reflection of effective inventory management, meaning your company is better aligned with customer demand and has optimized its supply chain.
- Competitive advantage. Efficiency turnover of inventory can help businesses respond faster to market and demand changes, making you more competitive in quickly changing spaces.
- Profitability and ROI. Holding onto inventory incurs costs such as storage, insurance, and potential spoilage. Keeping DIO low can help reduce these expenses, thereby improving profitability.
How is DIO used in inventory management?
DIO is used to optimize the management of inventory by:
- Identifying areas for improvement, such as refining demand forecasting
- Using your own figure to benchmark against industry standards
- Finding ways to manage working capital more effectively
How to calculate DIO?
To calculate days inventory outstanding, you’ll need two figures:
- Average inventory: The average value of your inventory across the period being measured.
- Cost of goods sold (COGS): The total of the direct costs incurred to produce the goods sold for the period in question.
From there, the formula is pretty simple:
DIO = (Average inventory / COGS) x 365
Let’s illustrate with an example.
Examples of days inventory outstanding
First, we need to get our figures together.
We’ll find our cost of goods sold on the income statement. Let’s say we have COGS valuing $2,400,000 for the previous year.
Next, we want to calculate our average inventory. An easy way to do this is to take our beginning inventory, add it to our ending inventory, and divide it by two to get an average.
In this case, our beginning inventory was $200,000 and our inventory was $300,00, giving us an average inventory of $250,000.
Then, we’re simply going to use the DIO formula outlined above:
(250,000 / 2,400,00) x 365 = 38.04 days
This tells us that it takes us an average of 38 days to sell our inventory on hand.
What does DIO tell business leaders?
So, what kind of information can we draw from our DIO figure?
There are four key insights we can draw.
1. Inventory management efficiency
DIO tells us about how efficient our inventory management practices are.
A low DIO indicates that a business is efficiently turning over inventory, signaling strong demand for products, minimal waste from unsold goods, and an optimized production or purchasing process.
2. Improving operational performance
DIO can be used as a good metric for understanding how new procedures that are implemented impact efficiency.
Business leaders can set inventory targets, benchmark against industry normals or historical performance, and implement strategies such as:
- Production optimization
- Demand forecasting
- Refining their purchasing approach
- Pinpointing inefficiencies in inventory turnover
- Improving sales forecasting
- Discontinuing slow-moving items by calculating DIO for different product categories
3. DIO in relation to other metrics
Days inventory outstanding is just one component of a broader framework and set of metrics used to measure the efficiency of an organization’s working capital management.
DIO is used alongside DSO and DPO to get a broader picture of overall operational efficiency.
4. Cash conversion cycle (CCC)
When these three metrics are used together, business leaders can calculate the cash conversion cycle (CCC), a measurement that tells them how quickly they can turn investments in inventory back into cash.
A lower CCC signals that a business is able to convert its inventory and receivables into cash faster. This is a positive sign for cash flow management, meaning the business can then reinvest in more inventory or other growth initiatives.
Comparing DIO to inventory turnover ratio
Days inventory outstanding and inventory turnover ratio are two metrics used to measure inventory efficiency but in different ways.
While DIO reflects the average number of days it takes to turn over your inventory, the inventory turnover ratio tells you how many times inventory is sold and replaced in a given period (e.g. a quarter).
DIO provides a time-based view, meaning it's useful for assessing cash flow and operational efficiency. ITR, on the other hand, gives a frequency-based perspective.
How to improve days inventory outstanding?
There are a number of ways businesses can improve their DIO metric. Here are some powerful strategies you can put in place right now.
1. Improve demand forecasting
One of the best ways to improve your DIO is to get a better understanding of what demand for your products looks like.
Analysis of historical sales patterns is helpful, but advanced predictive analytics tools can go a step further, looking at market trends, customer buying patterns, and the prospective impact of sales and marketing strategies on demand.
This can help you better match your inventory levels with actual customer demand.
2. Streamline supply chain
By focusing on timely and consistent delivery of materials and suppliers, you can avoid bottlenecks and delays, shortening the time it takes to turn raw inventory into sellable products.
Similarly, optimizing logistics processes such as transportation and warehousing can help you get inventory delivered and distributed faster, reducing DIO.
3. Implement just-in-time (JIT) inventory
JIT inventory management is a strategy that seeks to minimize stock on hand to align perfectly with actual sales demand.
You’ll need to already have reliable and capable suppliers in place and well-optimized logistics.
4. Increase sales efficiency
If you’re looking at DIO across different products, you may wish to consider implementing a targeted marketing campaign designed to increase demand for slow-moving products.
You can also look at diversifying sales channels to push existing inventory through the pipeline faster, including partnering with retailers or investing in ecommerce marketing programs.
5. Inventory rationalization
Inventory rationalization is the practice of reviewing and optimizing a company's inventory to ensure that only the most necessary, profitable, and in-demand items are being stocked.
It involves discontinuing, consolidating, or discounting slow-moving inventory to free up space for fast-selling items, or potentially even throwing out or donating unsellable stock.
For some businesses — such as retailers of holiday items — seasonal stock adjustments can also be a smart idea.
Master cash flow management
For SMBs looking to improve the control they have over cash flow, getting on top of days inventory outstanding is a great start.
Reducing your DIO means you’re converting inventory into cash faster, a good sign for liquidity and overall financial health.
Modern tools like BILL, our financial operations platform, are an important weapon in your arsenal, helping you to improve cash flow management with powerful features like:
- Accounts payable automation
- Automated invoice and payment collection
- Advanced reporting and forecasting features
Discover BILL’s huge range of powerful features for better spend and expense management today.
