This is part of a series on Cash Cycle Optimization. You can find the first article here.
How to optimize Inventory Days:
As a business owner, operations manager or CEO, there are many steps you can take to improve your company’s cash flow while simultaneously extend credit terms to your customers.
The goal is to optimize your Cash to Cash (C2C) conversion cycle. To calculate it, you can use this simple formula:
C2C = IDS + ARDS – APDS
Where:
IDS = Inventory Days
ARDS = Accounts Receivable/Revenue per Day
APDS = Accounts Payable/Revenues per Day
In this article, we’ll only be discussing what you can do to optimize your inventory days while also granting payment terms. You can head to our articles on ARDS and APDS.
Inventory days (also known as Days Inventory Outstanding or Inventory Period) is an efficiency ratio that measures the average number of days a company holds its inventory (in the form of raw materials, work-in-progress or finished goods) before finally selling it. Any company purchasing, manufacturing and selling physical goods on a regular basis should have a good understanding of their inventory period. A short inventory period means that the company is able to quickly convert its inventory into cash (high inventory liquidity).
How to calculate Inventory Days
The inventory period is measured by dividing inventory levels by costs of goods sold and multiplying it by 365.
IDS = (Ending Inventory/Costs of Goods Sold) x 365
Understanding Inventory Days
A high inventory period may point to overstocking, obsolescence or deficiencies in the product line or in the sales and marketing efforts. As a manager, you should identify the process flaws causing your inventory to stay longer on your shelves. If you find that your company is facing a high inventory period, you should immediately revise:
- Your forecasting
- Your procurement strategy
- The quality of goods supplied to you
- Your inventory valuation
- Your sales targets
- Your marketing efforts
It is also important to determine where most of your inventory is sitting. If it’s in the form of finished goods, then you might consider upping your sales and marketing process. On the other hand, if it’s in the form of work-in-progress material, you might be facing issues in your production line.
Remember, the sooner you’re able to sell your inventory, the quicker you’ll be able to access cash to purchase more inventory or invest in other parts of your business.
You should also consider other costs associated with inventory, such as holding costs, ordering costs and setup costs. You can read more about them in our inventory management article.