What’s it: Days of inventory on hand (DOH) is a financial ratio showing how many days on average a company converts its inventory into sales. It is inversely related to the inventory turnover ratio.
A lower DOH is preferable because it indicates the company is selling its available inventory more quickly. Thus, revenue is posted faster and less capital is tied up in inventory. Ultimately, it supports profitability and financial liquidity.
For example, suppose a company records a DOH of 90. That means, on average, it takes the company 90 days to convert its inventory into sales.
However, the ideal figure will vary between industries. For example, non-durable goods companies such as food require low DOH; otherwise, their costs can swell due to many spoiled or rotting goods. On the other hand, durable goods companies may still tolerate a higher DOH.
Why are the days on hand inventory important?
Days on hand inventory is useful for determining how efficiently a company manages each inventory dollar. In some businesses, such as retail, inventory is the biggest investment. Thus, management uses this ratio to understand how long capital is tied up in inventory. So, they can decide what to do to optimize and shorten the time it takes from procurement to sales.
Management also uses this ratio to make short-term forecasts about inventory. They establish the reorder points to ensure inventory flows smoothly throughout the production chain.
How to calculate days on hand inventory?
We can use two ways to calculate DOH. If you have calculated the inventory turnover ratio, you can use the second formula below. But, if you haven’t, you can apply the first formula.
- Days of inventory on hand = 365 * Average inventory / Cost of Goods Sold (COGS)
- Days of inventory on hand = 365 / Inventory turnover ratio
We can get inventory figures on the balance sheet in the current assets section. Then, we add the beginning inventory to the ending inventory and divide by 2 to get the average. Meanwhile, the cost of goods sold can be found in the income statement, usually in the second line after revenue.
Meanwhile, the number 365 refers to the number of days in a year or in the company’s normal operation. Some analysts might use 360 instead of 365.
Now, take a simple example. A company records the cost of goods sold of $2,000 on its income statement. Meanwhile, the average inventory for the last two years was $200. So, applying the above formula, we get DOH equal to 36.5 days = (365*$200/$2,000).
How to read the formula above?
As we can see from the formula, we know DOH is inversely proportional to inventory turnover. So, the higher the inventory turnover, the shorter it takes to sell its inventory. And, it’s getting more and more preferable.
In general, a lower DOH is preferable because it indicates a more efficient company. Companies can more quickly record revenue and collect payments from customers. On the other hand, less money is tied up in inventory. This situation leads to better liquidity and profitability.
Conversely, a higher DOH could indicate the company is struggling to increase sales. On the other hand, inventory is piling up and getting worn out. The company also has to bear the increase in related costs such as rent and utilities.
However, we must be careful using this ratio. This is because it can vary widely between industries. For example, firms in the durable goods or high-margin industries are able to maintain their inventories for a long time and therefore tend to have higher ratios.
On the other hand, companies in the non-durable goods industry, such as food manufacturers, need low DOH to avoid cost spikes and cash flow problems. Likewise, low-margin industries also do not tolerate low DOH as they have to sell more output to achieve their targeted profitability.
Why is the shorter DOH preferred?
DOH often fluctuates from time to time due to seasonal factors such as in businesses such as retail or hotels. Their sales increase during the holiday season and decrease during the normal season.
Because inventory binds money, a low DOH allows the company to have more capital to reinvest into the business. Companies can use it, for example, to introduce new lines or variants to respond quickly to consumer demands.
How to lower DOH?
Several alternatives to lower DOH. The first is to increase sales by designing the right marketing mix, such as offering discounts or sales promotions. It also requires reliable production support to make new supplies available when the old ones have been sold.
The second is to streamline business processes, from procurement to delivery to consumers. Third, integrating information between suppliers, retailers, and production facilities is necessary. In addition to choosing a reliable partner, technology support is also needed to do so.
A note when analyzing
Days of inventory on hand don’t tell us how long it took the company to collect the money. So even though it posted revenue, it didn’t necessarily mean cash was coming in.
A company may sell products on credit. And, under accrual accounting, the company records revenue when it has sold and shipped products even though it has not yet received payment.
In this case, the company recognizes revenue on its income statement. However, it does not record an increase in cash but accounts receivable (both are in the current assets section).
What to read next
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- Inventory Turnover Ratio: Formula, Calculation and How to Read It
- Days of Inventory on Hand: Formula and How to Calculate
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- Accounts Payable Turnover Ratio: How To Calculate And Read It
- Days Payable Outstanding: How to Calculate and Interpret it
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- Fixed Assets Turnover Ratio: How to Calculate and Interpret
- Asset Turnover Ratio: Calculation and Interpretation