What is the Inventory Conversion Period?
The inventory conversion period determines how much time it takes to convert the inventory into sales, i.e., the time from purchasing the new stock to the actual product sale. It is calculated as inventory divided by average sales or cost of sales and multiplied by 365 to know the exact days of inventory conversion into sales.
The high conversion period determines the slow cash conversion cycle and block of money in inventory. In contrast, a decreased conversion period reduces cash conversion cycles and unnecessary money blockage. It takes into account the average amount invested in the stock.
Table of contents
Key Takeaways
- The inventory conversion period estimates the time that it takes to convert the inventory into sales, which is the time from purchasing the new stock to the actual product sale.
- One may calculate it as inventory divided by average sales or cost of sales and multiply by 365 to understand the inventory conversion into sales exact days.
- The high conversion duration estimates the delayed cash conversion cycle and money block in inventory. A shorter conversion period, on the other hand, reduces cash conversion cycles and unneeded money blockage and takes into account the average amount invested in the stock.
Inventory Conversion Period Formula
The number of days or months the inventory converts into sales determines the cash conversion cycleDetermine The Cash Conversion CycleThe Cash Conversion Cycle (CCC) is a ratio analysis measure to evaluate the number of days or time a company converts its inventory and other inputs into cash. It considers the days inventory outstanding, days sales outstanding and days payable outstanding for computation.read more and improves the conversion period through efficient management and working on loopholes.
The formula is as under:-
Formula = Inventory / Cost of Sales * 365
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For eg:
Source: Inventory Conversion Period (wallstreetmojo.com)
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OR
Formula = Inventory / Sales * 365
OR
Formula = Inventory / Average Daily Sales
Inventory is taken as on the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more date. The cost of sales and average daily sales would be taken as a base for internal calculation purposes to know the exact conversion period. Whereas, for presentation in the financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, the net sales Net SalesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company's gross sales.read more for the year would be taken into account so that every reader could understand the analysis and compare it with the industry conversion ratio.
As sales price, less cost of sales is the gross profit marginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold.read more of the organization. Hence, some organizations do not take the average sales while calculating this period to determine the exact conversion period. In comparison, it is also a fact that the analyst calculates this period by considering sales. It is because it helps readers of financial statements to understand better. Ultimately, the company has to convert inventory into sales; hence, sales are the base for calculating the conversion cycle.
Example
The organization’s inventory, as on the balance sheet date, is $3 million, and average daily sales are $30,000. To calculate the inventory conversion period and determine how one can reduce it?
Solution:
Calculation of Yearly sale:
= $30,000 * 365
= $10,950,000
= 10.95 million
Formula = Inventory/ Sales * 365
- = 3 / 10.95 * 365 = 100 days
i.e. one can convert inventory into sales in 100 days
OR
- Average daily sales : $30,000 / $10,00,000 = 0.03 million
Formula = Inventory/ Average Daily Sales
- = 3 million / 0.03 million = 100 days
One can reduce it by adopting incentives to employees for faster production or just a time approach for inventory.
How to Interpret?
We can interpret the inventory conversion period as determining the number of days one can convert the inventory into sales to assess the average cash cycle and manage it better.
It helps the organization better inventory and purchase management and decides whether inventory is to be purchased or manufactured. And to determine the need for more investment and the return on the same.
Issues
There are two issues involved here: –
- One may calculate the period the inventory converts into sales and cash. But, it ignores that there is a credit period to be allowed to debtorsDebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. read more, and that credit periodCredit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy.read more is not included. i.e., its conversion into cash takes longer than determined by calculating the inventory conversion period. It only calculates the time of inventory conversion into sales, not the inventory into cash. The inventory into cash conversion may require more extensive time than sales because of the credit period allowed to debtors.
- While calculating this period assumes that all items are purchased or manufactured in the company. Therefore, the whole inventory management and conversion period can be controlled and reduced drastically if the company goes for outsourcing production.
Frequently Asked Questions (FAQs)
What is a reasonable inventory conversion period?
Most industries’ ideal inventory turnover ratio will be between 5 and 10. The company may sell and restock inventory approximately every one to two months.
One may calculate it as inventory divided by average sales or cost of sales and multiplied by 365 to obtain the inventory conversion into sales exact days.
The inventory conversion period is when a company should invest cash when it converts materials into a sale. In addition, closely regulating the conversion period may result in a reduced cash requirement by a business.
The inventory conversion period refers to the time needed to get materials, manufacture, and sell the product. Moreover, a company may invest cash while converting materials into a sale.
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