Inventory holding period

The inventory holding period is a key performance indicator for managers to assess liquidity. It measures the ability of a business to manage its assets and how long it takes to convert them into cash or income.

Meaning and formula for inventory holding period

Inventory Holding Period is a ratio that depicts the number of days for which an organisation holds inventory before sales. It shows how many days it takes for inventory to rotate in the business. An average stock = (Opening stock + Closing stock) / 2.

Inventory holding period, also known as days in inventory, can be calculated by dividing the average inventory by the cost of goods sold per day, depicted by the following formulas:

Inventory Holding Period (in no. of days)= (Average Inventory / Cost of goods sold)×365

OR

Inventory Holding Period (in no. of days)=365 / Inventory Turnover Ratio

The inventory holding period is an efficiency ratio. Efficiency ratios show how a business manages its assets and liabilities. They are an important indicator of the ability of the company to generate cash.

Importance of inventory holding period

The inventory holding period tells the company how long funds are tied up in the form of inventory before they are realised as sales. The value of the inventory holding period varies depending upon the type of business and industry. 

The service industry will have no inventory and, hence, the value of the inventory holding period will be zero. Businesses selling consumable products will have a higher inventory holding period compared to a business selling luxury products. 

Therefore, while assessing the value of the ratio, they are usually compared with standards and businesses in the same industry. It can have a high or low value based on the comparison. 

Either of them could be interpreted in different ways:

• High inventory holding period:
  • It occurs when the average inventory is increasing compared to industry standards.
  • A high inventory holding period signifies that money is tied up in the form of inventory for longer periods. The increasing inventory holding period is a warning sign for businesses since it indicates that sales are slowing down. 
  • But a high inventory turnover may be a good sign in some cases. It can show the ability of a business to absorb sudden spurts in demand effectively, especially during peak seasons.
• Low inventory holding period
  • It occurs when the inventory held is lower when compared to industry standards.
  • A lower inventory holding period indicates good efficiency since it indicates that less time is required for the stock to be realised as sales income. Decreasing the inventory holding period means the company makes more sales in a shorter period. 
  • However, in some cases, it may indicate rising costs of goods sold, which must be reviewed constantly.

Illustrations on the inventory holding period

(1) ABC company maintained an average stock of Rs 80,000 in 2019, Rs 1,00,000 in 2020 and Rs 1,50,000 in 2021. The cost of goods sold was Rs 10,00,000 in 2020 and Rs 18,00,000 in 2021. By applying the above formula, we get the following:

Inventory Holding Period (2020)= {[(80,000+1,00,000) /2] / 10,00,000}×365 = 32.85 days

Inventory Holding Period (2021)=
{[(1,00,000+1,50,000) /2] / 18,00,000}×365 = 25.35 days

In the above illustration, the cost of goods sold and inventory held has increased year on year. The inventory holding period has decreased in 2021 to 25.35 days, compared to 32.85 days in 2020. This indicates the increase in efficiency with respect to costs incurred in producing goods. The business can convert more of its inventory into sales in 2021 than in 2020. 

(2) XYZ company maintained an average stock of Rs 80,000 in 2019 and Rs 1,20,000 in 2020 and Rs 1,80,000 in 2021. The cost of goods sold was Rs 10,00,000 in 2020 and Rs 14,00,000 in 2021. By applying the above formula, we get the following:

Inventory Holding Period (2020)=
{[(80,000+1,20,000) /2] / 10,00,000}×365 = 36.50 days

Inventory Holding Period (2021)=
{[(1,20,000+2,00,000) /2] / 14,00,000}×365 = 41.71 days

In the above illustration, there is an increase in goods produced and inventory held. Despite this, the inventory holding period has increased from 36.50 days in 2020 to 41.71 days in 2021. This indicates the increasing inefficiency over the years. The business cannot clear a substantial amount of its stock produced in the year, and sales have slowed down. This is a warning sign for the managers who have to take decisions to reverse this increase.

How to ensure optimum inventory holding period

Various steps can be taken to ensure the inventory holding period is at the optimum level:

• Efficient forecasting – Managers must forecast sales and purchases properly. By doing so, businesses will know exactly how much materials to purchase and goods to produce. This will help maintain the optimum level of inventory.
• Improving sales campaigns – Marketing the business’s products will boost sales, which will impact the inventory holding period. With the increase in sales, more inventories will be sold in a lesser period.
• Eliminating redundant/excess stock – Selling excess inventory reduces the average inventory held, decreasing the inventory holding period ratio. Selling redundant stock enables the business to focus on producing newer products.
• Optimising manufacturing process – This helps to produce goods faster and maintain lower quantities of materials in stock. This will also help to meet sales targets faster and will promote growth.