Wall Street Prep

Days Inventory Outstanding (DIO)

Days Inventory Outstanding (DIO) and Inventory Turnover Formula Concept Explanation with Excel Calculation Tutorial

Learn Online Now

Days Inventory Outstanding (DIO)

In This Article
  • What is the formula used to calculate days inventory outstanding (DIO)?
  • Would a company want a higher or lower days inventory outstanding (DIO)?
  • How is days inventory outstanding (DIO) and inventory turnover related?
  • How can you project inventory using the inventory turnover and DIO metrics?

On the balance sheet, the inventory line item represents the dollar value of the raw materials, work-in-progress goods, and finished goods of a company.

A comparative benchmarking analysis of a company’s inventory turnover and DIO relative to its industry peers provides useful insights into how well inventory is being managed.

The average inventory turnover and DIO varies by industry; however, a higher inventory turnover and lower DIO is typically preferred as it implies the management of inventory is closer to an optimal state.

In addition to being an indicator of ordering and inventory management efficiency, a high inventory turnover ratio and low DIO means higher free cash flows. That is why the inventory turnover ratio and days inventory outstanding (DIO) are valuable metrics to track for companies, especially those selling physical products (e.g., retail, e-commerce).

For purposes of forecasting, inventory is ordinarily projected based on either inventory turnover or days inventory outstanding (DIO).

Inventory Turnover: Concept and Formula

To start, we will first discuss the concept of inventory turnover, which is typically expressed on an annual basis. To reiterate, inventory turnover refers to how often a company’s inventory balance needs to be replenished (i.e., “turned over”) each year.

Since a higher turnover ratio means the company is selling off its inventory balance more frequently, companies strive to increase the turnover count to minimize the retention of existing inventory in order to avoid the build-up of unsellable/low-demand products.

If the inventory turnover is higher relative to comparable companies in the same industry, this is usually interpreted as a positive sign as it means:

  1. The company is selling off its products quickly (i.e., demand-based ordering, “just-in-time”)
  2. There is adequate customer demand in the market for the product being offered
  3. The pricing of the product appears to be set around a reasonable range

In contrast, a low inventory turnover ratio indicates the company is struggling to sell its products – meaning, less free cash flows since more of the FCFs are tied up in operations and cannot be deployed for other purposes.

The formula for inventory turnover is the cost of goods sold divided by the average (or ending) inventory balance.

Inventory Turnover = COGS / Average Inventory

Note that the average between the beginning and ending inventory balance can be used for both the calculation of inventory turnover and DIO.

This is because the income statement covers a specific period, whereas the balance sheet is a snapshot at one particular point in time – thus, the average is used to prevent a timing mismatch between the numerator (an income statement item) and denominator (a balance sheet item).

However, in practice, the ending balance of inventory is often used. Unless the company operates in a highly seasonal industry with fluctuations in sales throughout the year, the difference between methodologies tends to be insignificant in most cases.

Days Inventory Outstanding (DIO): Concept and Formula

DIO measures the number of days required for a company to sell off the amount of inventory it has on hand. Thus, companies attempt to minimize the DIO to limit the time that inventory is sitting in their possession.

An increase in an operating working capital asset, such as inventory, represents an outflow of cash, which is why in the free cash flow formula, an increase in working capital (i.e., current operating assets minus current operating liabilities), results in a reduction in FCFs. If the inventory balance increases, that means more cash is tied up in the operations of the business, as it is taking longer for the company to sell and get rid of its inventory as it is to produce it.

High Days Inventory Outstanding (DIO) Low Days Inventory Outstanding (DIO)
  • If the number of days it takes on average to clear out the inventory is high relative to comparable peers, there may not be enough demand for the product, the pricing might be too expensive, or it may be time to reconsider the target customer profile, etc.
  • As a general rule of thumb, lower DIO is viewed more favorably since it implies the company is more efficient at selling its inventory (and is avoiding stock-piling inventory)
  • The company may be failing to convert inventory into sales or is not managing inventory efficiently compared to others due to an ineffective marketing strategy where it fails to get enough exposure compared to others in its sector
  • If a company has a low DIO, that means it is converting inventory into revenue more quickly – meaning more FCFs are available for reinvestments or other purposes like paying down debt
  • Or in the worst-case scenario, the product may have become obsolete and substantial discounts would be required to get rid of the inventory (or potentially incur an inventory write-down)
  • One caveat is that companies with a low DIO might be overwhelmed if demand were to see a sudden increase; if inventory were to ever fall to zero, then the company would actually be missing out on potential sales

The formula for calculating DIO involves dividing the average (or ending) inventory balance by COGS and multiplying by 365 days.

Days Inventory Outstanding (DIO) = (Average Inventory / Cost of Goods Sold) * 365 Days

Another method to calculate DIO is to divide 365 days by the inventory turnover ratio.

Days Inventory Outstanding (DIO) = 365 Days / Inventory Turnover

Excel Template Download

To go through an example inventory projection exercise, fill out the form below.

Submitting ...

Inventory Turnover & Days Inventory Outstanding (DIO) Calculation

The two historical data points provided are the cost of goods sold (COGS) of $100mm and inventory of $20mm. Moreover, COGS is growing each year at 5% year-over-year (YoY). Based on that information, we can calculate the inventory by dividing the $100mm in COGS by the $20mm in inventory to get 5.0x for the inventory turnover ratio in 2020. This means that on average, the company goes through its inventory and must restock it five times per year.

Inventory Turnover Formula

Next, the DIO can be calculated by dividing the $20mm in inventory by the $200mm in COGS and multiplying that by 365 days – which results in 73 days. This means that it takes the company roughly ~73 days to clear out their inventory, on average.

DIO Formula

For purposes of simplicity, we are using the ending inventory balance in our formulas. But if you wanted to use the average inventory balance, it would just be the sum of the beginning and ending inventory balance divided by two.

Next, we will carry forward the inventory turnover assumption of 5.0x and the DIO assumption of 73 days to project future inventory levels. The screenshot below shows the formula for projecting inventory throughout the forecast period.

Inventory Formula

The toggle in the top right corner cycles between the two approaches for forecasting:

  • If the toggle is set to “Turnover”, COGS is divided by the inventory turnover assumption.
  • If set on “DIO”, the days inventory outstanding assumption is divided by 365 days and then multiplied by the COGS

On the job, it is far more common to see models that project inventory using the DIO approach (often denoted as “Inventory Days”) than based on turnover days. However, the projected inventory balances are identical under both approaches.

The completed model output is shown below:

Inventory Forecast Complete

Step-by-Step Online Course

Everything You Need To Master Financial Modeling

Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.

Enroll Today
Comments
guest
0 Comments
Inline Feedbacks
View all comments
Share
Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

Learn More
X

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.