Inventory Conversion Period: The Ultimate Guide for 2023
In this article, we cover what inventory conversion period is and how to calculate it. We also provide a simple 3-step framework to interpret your inventory conversion period correctly, with real-world examples. Read on to learn more.
What Is Inventory Conversion Period?
The inventory conversion period indicates how long it takes for a company to sell its entire stock of inventory on average. This metric provides insight into the company's inventory management efficiency, revealing how swiftly products move from the warehouse shelves to the hands of consumers.
Example: If Tech Gadgets Ltd. has an inventory conversion period of 30 days, it means they typically sell all their stocked items within a month.
How to Calculate the Inventory Conversion Period
Understanding the inventory conversion period is key to effective inventory management. The formula to calculate it is:
Inventory Conversion Period (days) = (Average Inventory / Cost of Goods Sold) x 365
Take Fashion Wear Inc. as an example. If they have an average inventory of $500,000 and their cost of goods sold (COGS) is $2,000,000 for the year, their inventory conversion period is:
Average Inventory = $500,000
Cost of Goods Sold (COGS) = $2,000,000
Inventory Conversion Period = (500,000 / 2,000,000) x 365= 91.25 days.
Hence, on average, it takes Fashion Wear Inc. 91.25 days to sell its entire stock of inventory.
3-Step Framework to Interpret an Inventory Conversion Period
To effectively gauge a company's efficiency in turning inventory into sales, it's essential to interpret the inventory conversion period correctly.
Here's our simple 3-step framework to guide you:
Step 1: Compare Against Industry Averages
Obtain industry benchmarks and compare your company's conversion period to the average.
Example: Auto Drive Cars finds out their conversion period is 40 days. When they look at industry averages, they discover most competitors average around 30 days. This could suggest Auto Drive Cars might be holding onto inventory for too long.
Step 2: Assess Cash Flow Impact
Evaluate the implications of your conversion period on your cash flow.
Example: Book Nook Store determines their conversion period is a swift 10 days. This short duration implies they're getting returns on their inventory investments quite rapidly, leading to improved cash flow.
Step 3: Monitor Trends Over Time
Regularly check how the conversion period fluctuates over months or years.
Example: Sports Gear Outlet tracks their inventory conversion period and finds it has risen from 45 days to 60 days within a year. This trend indicates they might be overstocking or facing a decrease in demand.
To understand their recent cash flow decline, HealthyJuice Co. decided to examine their inventory conversion period. They followed our step-by-step framework:
Step 1: Comparing Against Industry Averages
HealthyJuice Co. obtains industry benchmarks for juice companies to see how they stack up. Upon research, HealthyJuice Co. finds out their conversion period is 50 days. When they examine industry averages, they realize that most juice companies are averaging around 40 days. This longer duration suggests that HealthyJuice Co. might be holding onto inventory longer than optimal.
Step 2: Assessing Cash Flow Impact
They evaluate the potential cash flow implications of their 50-day conversion period. Recognizing the importance of cash flow in their business, HealthyJuice Co. calculates that by reducing their conversion period closer to the industry average, they could potentially free up significant working capital, boosting their liquidity.
Step 3: Monitoring Trends Over Time
HealthyJuice Co. looks at historical data to see if there's been a change in their conversion period over the past year. The company discovered that over the past year, their conversion period increased from 40 days to the current 50 days. This rising trend points towards possible challenges like overstocking or a decrease in market demand for their products.
We hope this article has given you a better understanding of what an inventory conversion period means and how to interpret it correctly.