What is Days Inventory Outstanding?
Days Inventory Outstanding (DIO) measures the number of days it takes on average before a company needs to replace its inventory.
DIO is often measured to improve a company’s go-to-market, sales & marketing, and product pricing strategies based on historical customer demand and spending patterns.
How to Calculate Days Inventory Outstanding (DIO)?
DIO, or “days inventory outstanding”, 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 their days inventory outstanding to limit the time that inventory is sitting in their possession.
In order to compute a company’s days inventory outstanding, two inputs are necessary:
- Inventory: 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.
- Cost of Goods Sold (COGS): On the income statement, the COGS line item represents the direct costs incurred by a company while selling its goods or services to generate revenue.
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 than it is to produce it.
Days Inventory Outstanding Formula (DIO)
The formula for calculating DIO involves dividing the average (or ending) inventory balance by COGS and multiplying by 365 days.
Conversely, another method to calculate DIO is to divide 365 days by the inventory turnover ratio.
What is a Good Days Inventory Outstanding?
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).
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What is the Difference Between Days Inventory Outstanding vs. Inventory Turnover?
The concept of inventory turnover is closely tied to days inventory outstanding (DIO), as inventory turnover refers to how often a company’s inventory balance needs to be replenished (i.e., “turned over”) each year.
For purposes of forecasting, inventory is ordinarily projected based on either inventory turnover or days inventory outstanding.
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:
- The company is selling off its products quickly (i.e., demand-based ordering, “just-in-time”)
- There is adequate customer demand in the market for the product being offered
- 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.
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 Calculator (DIO)
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Operating Assumptions
Suppose we’re given two historical data points belonging to a hypothetical company from 2020, which are a cost of goods sold (COGS) of $100mm and an inventory balance of $20mm. Moreover, COGS is growing each year at 5% year-over-year (YoY).
- COGS = $100 million
- Inventory = $20 million
- COGS Growth (Step Function) = +5% YoY
2. Historical Inventory Turnover Calculation and Ratio Analysis
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.
The 5.0x inventory turnover ratio implies that, on average, the company goes through its inventory and must restock it five times per year.
- Inventory Turnover, 2020A = $100 million / $20 million = 5.0x
3. Historical Days Inventory Outstanding Calculation Analysis
Next, the company’s days inventory outstanding (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 its inventory, on average.
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.
In the next step, we will carry forward the inventory turnover assumption of 5.0x and the DIO assumption of 73 days to project future inventory levels.
- Inventory Turnover = 5.0x
- Days Inventory Outstanding (DIO) = 73 Days
5. Inventory Forecast (DIO and Inventory Turnover Method)
The switch toggle in the top right corner cycles between the two approaches for forecasting:
- “Turnover” Approach: If the toggle is set to “Turnover”, COGS is divided by the inventory turnover assumption.
- “DIO” Approach: If the switch is set to “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 equivalent under both approaches.
From our starting period (2020) to the final year of the forecast (2025), we can see how our company’s inventory balance has increased by $20 million to $26 million.
- Inventory, 2021E = $21 million
- Inventory, 2022E = $22 million
- Inventory, 2023E = $23 million
- Inventory, 2024E = $24 million
- Inventory, 2025E = $26 million
