The effectiveness of management decisions relating to inventory can be analyzed by calculating the number of days of sales that can be serviced by existing inventory levels.
The number of days of sales in inventory is calculated by dividing average inventory by the cost of goods sold and multiplying the result by 365 days.
The BDCC financial data for 2020 and 2021 required to calculate this ratio are shown below.
The calculation indicates that BDCC is investing more in inventory in 2021 than in 2020 because there are 98 days of sales in inventory in 2021 versus 73 days in 2020. BDCC has approximately 3 months of sales with its existing inventory (98 days represents about 3 months). The increase from 2020 to 2021 may warrant investigation into its causes.
A declining number of days of sales in inventory is usually a sign of good inventory management because it indicates that the average amount of assets tied up in inventory is lessening. With lower inventory levels, inventory-related expenses such as rent and insurance are lower because less storage space is often required. However, lower inventory levels can have negative consequences since items that customers want to purchase may not be in inventory resulting in lost sales.
Increasing days of sales in inventory is usually a sign of poor inventory management because an excessive investment in inventory ties up cash that could be used for other purposes. Increasing levels may indicate that inventory is becoming obsolete (consider clothing) or deteriorating (consider perishable groceries). Obsolete and/or deteriorating inventories may be unsalable. However, the possible positive aspect of more days of sales in inventory is that there can be shorter delivery time to customers if more items are in stock.
Whether Big Dog’s increasing days of sales in inventory is positive or negative depends on management’s objectives. Is management increasing inventory to provide for increased sales in the next year, or is inventory being poorly managed? Remember that ratio analyses identify areas that require investigation. The resulting investigation will guide any required action.
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