What is the Inventory Conversion Period?
Inventory Conversion Period determines how much time it takes to convert the inventory into sales i.e the time taken from the purchase of the new inventory to the actual sale of the product. It is calculated as inventory divided by average sales or cost of sales and multiplied by 365 so as to know the exact days of conversion of inventory into sales.
The high conversion period determines the slow cash conversion cycle and block of money in inventory. In contrast, a decreased conversion period improves the cash conversion cycles and unnecessary blockage of money. It takes into account the average amount invested in inventory.
Inventory Conversion Period Formula
It is the number of days or months in which the inventory is converted into sales to determine 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. and improve the conversion period by efficient management and working on loopholes, if any.
The formula is stated as under:
Formula = Inventory / Cost of Sales * 365
Formula = Inventory / Sales * 365
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. 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., the net salesNet 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. 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. 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 taking into account sales. It is because it helps readers of financial statement to understand better and ultimately, the company has to convert inventory into sales; hence sales is taken as the base for calculating the conversion cycle.
Inventory of the organization as on balance sheet date is $ 3 million, and average daily sales are $ 30,000 to calculate the inventory conversion period and also determine how it can be reduced?
- 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. inventory can be converted into sales in 100 days
- Average Daily Sales : $ 30,000 / $ 10,00,000 = 0.03 Million
Formula = Inventory/ Average Daily Sales
- = 3 million / 0.03 million = 100 days
It can be reduced by adopting incentives to employees for faster production or by just in time approach for inventory.
How to Interpret?
The inventory conversion period can be interpreted as determining the number of days the inventory can be converted into sales to assess the average cash cycle involved in inventory and to manage it better if possible.
It helps the organization in better inventory and purchase management and to decide whether inventory to be purchased or manufactured. And to determine the need for more investment and the return on the same.
There are basically two issues involved here:
- It is calculated for determining the period in which the inventory is converted into sales and, ultimately, the cash. But it ignores the fact that there is a credit period also to be allowed to debtorsDebtorsA debtor is a person or entity that owes money to the other party in a transaction. The receiver is referred to as the creditor, and the payment terms vary for each transaction based on the terms and conditions agreed upon by the parties., 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. is not included. I.e., its conversion into cash takes a longer time then it is determined by calculating the inventory conversion period. It only calculates the time of conversion of inventory into sales, not the conversion of inventory into cash as the conversion of inventory into cash may require the more extensive time then convert into sales because of the credit period allowed to debtors.
- While calculating this period, it is assumed that all items are either purchased or manufactured in the company. If the company goes for outsourcing production, the whole inventory management and conversion period can be controlled and reduced drastically.
This article has been a guide to the inventory conversion period. Here we discuss formulas to calculate inventory conversion period along with example and interpretation. You may learn more about financing from the following articles –