What is Inventory Days?
Inventory Days measures the average amount of time in which a company’s inventory is held on hand until it is sold.
How to Calculate Inventory Days (Step-by-Step)
On the balance sheet, the “Inventory” line item appears in the current assets section and represents the outstanding dollar value of a company’s entire inventory and consists of three primary components:
- Raw Materials
- Work-in-Progress (WIP)
- Finished Goods
The following list describes some practical use-cases of the inventory days KPI:
- Working Capital Management: The quicker a company can sell its inventory on hand – i.e. reduce the number of days during which inventory remains unsold – the more operationally efficient the management team is at managing its working capital. In addition, the less time it takes a company to sell its inventory implies the company’s existing strategies around acquiring new customers and its sales and marketing tactics are effective.
- Demand Planning: A frequent hurdle faced among companies, especially at the earlier stages in their lifecycle, is accurately predicting customer demand. While there are various external factors at play, such as the state of the economy and unexpected developments in the market like a new entrant, a well-run company’s inventory supply generally converges near the actual demand from customers, albeit building precise projections on a moving target is much easier said than done.
- Forecasting Inventory: The standard method by which a company’s ending inventory balance is projected in a 3-statement model is the inventory days metric, which serves as the underlying assumption that drives the forecast.
The process of calculating a company’s inventory days can be broken into four steps:
- Step 1. Calculate the Average Inventory Balance (Beginning of Period and End of Period Balance ÷ 2)
- Step 2. Determine the Cost of Goods Sold (COGS) Incurred in the Current Period
- Step 3. Divide the Average Inventory Balance by COGS
- Step 4. Multiply the Resulting Figure by the Number of Days in the Period (e.g. 365 Days)
Inventory Days Formula
The formula to calculate inventory days is as follows.
- Average Inventory: The average inventory balance is calculated by taking the sum of the inventory balances as of the beginning and end of the period and dividing it by two.
- Cost of Goods Sold (COGS): The cost of goods (COGS) line item can be found on the income statement and represents the incurred costs that are related to a company’s revenue model (e.g. direct material, direct labor costs).
While COGS is a line item found on the income statement, the inventory line item is found in the current assets section of the balance sheet. In effect, there is a timing mismatch as the income statement measures performance across a period, but the balance sheet is a “snapshot” of a company’s assets, liabilities, and shareholder’s equity at a specific point in time.
The average inventory balance is thereby used to fix the timing misalignment. However, there is usually no material impact on the completed model if the ending balance of inventory is used in lieu of the average balance, although there can be outliers, which would be signified by substantial differences between a company’s inventory balance.
What is a Good Inventory Days (High vs. Low)
Since the inventory days KPI tracks the time required by a company to sell through its inventories, companies strive to reduce the number of days in which inventory is kept on hand before being sold, i.e. they aim for quicker cycles of inventory orders.
- Low Inventory Days: High Near-Term Liquidity and More Cash on Hand
- High Inventory Days: Less Near-Term Liquidity and Reduced Cash on Hand
Otherwise, the company’s inventory is waiting to be sold for a prolonged duration – which at the risk of stating the obvious – is an inefficient situation to be in that management must fix.
Whether drastic measures are required or not is dictated by the circumstances at hand. But at a bare minimum, the management team (and supporting team) should spend time researching the following:
- Cause of the Inventory Build-Up
- Target Customer Profile Research and Current (or New) Spending Patterns
- Market Demand Analysis and Segmentation
- Industry Trends and Risks
- Competitor Offerings
If the time needed by a company to sell through its inventory is higher than comparable companies operating in the same industry, that is a potential red flag that adjustments to the current business model and inventory management practices might be necessary.
One mistake to avoid, however, is to compare the inventory days of companies in completely different industries, as that would be an unfair comparison where the interpretation is likely to be incorrect (i.e. “apples-to-oranges”).
In the best-case scenario, no further action might be necessary, as the accumulation of inventory could be a byproduct of targeting a niche customer segment and operating in a cyclical market that balances out over the long run.
- Scenario 1: For example, a high-end luxury retailer selling products at very high price points is likely not to be too concerned if their inventory on hand is increasing, especially if the economy is on the verge of entering a recession and revenue figures are stable, i.e. the reduced demand is cyclical and part of the long-term business model.
- Scenario 2: In contrast, a low-end clothing retailer targeting a far broader market, i.e. low to middle class consumers, with inventory days expanding substantially would be of greater concern. This retailer, compared to the prior example, is more likely to view the trend as an urgent signal to regroup internally and adjust their current spending (and growth) strategies.
Inventory Days Calculator – Excel Template
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Step 1. Historical Inventory Days Calculation Example
Suppose you’re tasked with forecasting a company’s ending inventory for a five-year period given the following historical data.
|Cost of Goods Sold (COGS)||($80 million)||($100 million)||($140 million)|
|Inventory||$10 million||$12 million||$15 million|
To have a point of reference to base our operating assumptions upon, our first step is to calculate the historical inventory days in the historical periods (2020 to 2022).
By adding the current and prior year inventory balance, and then dividing it by two, the inventory days calculated comes out to 40 days and 35 days in 2021 and 2022, respectively.
- Inventory Days, 2021A = 40 Days
- Inventory Days, 2022A = 35 Days
Based on the recent downward trend from 40 days to 35 days, the company seems to be moving in the right direction in terms of becoming more efficient at clearing out its inventory quickly.
Note: The cost of goods sold (COGS) line item was entered as a negative number, so a negative sign must be placed in front of the inventory days formula, otherwise the KPI will be a negative integer.
Step 2. Inventory Days Forecast Assumptions
The next part of our exercise comprises forecasting our company’s ending inventory across the five-year projection period.
The growth rate of our company’s cost of goods sold (COGS) is assumed to reach 4.0% by the end of 2027, with the change in the growth rate occurring in equal increments.
Using a step function, we’ll reduce the growth rate in 2022 by 7.2% each period until reaching our target 4.0% growth rate by the end of the forecast.
If the historical inventory days metric remains constant, the historical average can be used to project the inventory balance. However, if there is a clear directional trend in recent years – as in the case of our hypothetical scenario – it is recommended to follow the downward (or upward) trajectory, while remaining cognizant of the industry average (i.e. to perform a “sanity check” to ensure the assumptions are within reason).
Using a step function, the projected COGS incurred by the company is as follows.
- COGS, 2023 = ($186 million)
- COGS, 2024 = ($234 million)
- COGS, 2025 = ($276 million)
- COGS, 2026 = ($307 million)
- COGS, 2027 = ($320 million)
The projection of the cost of goods sold (COGS) line item finished, so the next step is to repeat a similar process for our forward-looking inventory days assumptions that’ll drive the forecast.
We’ll assume the average inventory days of our company’s industry peer group is 30 days, which we’ll set as our final year assumption in 2027. Like earlier, a step function is used to incrementally reduce our assumption from 35 days at the end of 2022 to our target 30-day assumption by the end of 2027, which implies a decline of approximately one day per year.
- Inventory Days, 2023 = 34 Days
- Inventory Days,2024 = 33 Days
- Inventory Days, 2025 = 32 Days
- Inventory Days, 2026 = 31 Days
- Inventory Days, 2027 = 30 Days
Step 3. Forecasted Ending Inventory Calculation Example
We now have the necessary components to input into our forecasted inventory formula.
In closing, we arrive at the following forecasted ending inventory balances after entering the equation above into our spreadsheet.
- Ending Inventory, 2023 = $17 million
- Ending Inventory, 2024 = $21 million
- Ending Inventory, 2025 = $24 million
- Ending Inventory, 2026 = $26 million
- Ending Inventory, 2027 = $26 million