Days in Inventory or DII is also known as inventory days. Essentially, it measures the number of days inventory stays in the system.
On the balance sheet, inventory is an asset. However, think of it as a liability. It ties up cash that might be used for other purposes. It also requires additional expenses such as costs for warehousing space, utilities, insurance, and staff to manage the inventory. Inventory is also subject to obsolescence and shrinkage. On the other hand, too little inventory means a company may not be able to meet customer needs. The goal is to meet customers’ needs and minimize inventory. The ability to free inventory investment allows a company to invest in other ways.
The formula for DII is:
Inventory is found on the balance sheet. You calculate average inventory by adding inventory at the end of the previous period to the inventory at the end of the current period, then dividing by 2. (Some companies use just the ending inventory number.) For example, if inventory at the end of year 1 is $1,400 and at the end of year 2 is $1,000:
Average inventory for year 2 = ($1,400 + $1,000) / 2
= $2,400 / 2
The denominator of DII is cost of goods sold (COGS) per day, found on the income statement. This tells us how much inventory is actually used each day. To get a daily number, divide COGS by the number of days in a year. (Financial folks tend to use 360 as the number of days in a year, simply because it’s a round number.) For example, if the income statement for year 2 shows COGS of $7,200, you would determine the inventory consumed per day as:
COGS per day = $7,200 / 360 = $20.
To complete the DII calculation:
DII = ($1,400 + $1,000)/2 / $7,200/360
= $1,200 / $20
In this example, inventory stayed in the system for an average of 60 days.
(Excerpts from Financial Intelligence, Chapter 24 – Efficiency Ratios)
Inventory flows through a company, and it can flow at a greater or lesser speed. Moreover, how fast it flows matters a lot. If you look at inventory as “frozen cash,” then the faster you can get it out the door and collect the actual cash, the better off you will be.
… The lower the inventory days, the tighter your management of inventory and the better your cash position. So long as you have enough inventory on hand to meet customer demands, the more efficient you can be, the better.