In finance books you will most often find the following formula for the calculation of the inventory days:
Inventory days = Average Inventory / COGS * 365
There is nothing wrong with this formula. However, there are a few things that one needs to watch out for when using it.
Don’t use the sales figure!
Sometimes the formula you will find in finance books includes sales instead of COGS. This is fundamentally wrong, as sales figure includes a mark-up added on top of the manufacturing costs. The mark-up is realised only when the sale has actually been concluded.
When a company purchases raw materials it needs for its manufacturing processes, it will book them at cost in its balance sheet. We will not dig deep into the management accounting practices here, but it is important to highlight that during the manufacturing process, the value of the raw materials used is enhanced by allocating a portion of the variable manufacturing expenses, direct labour expenses, and direct and indirect depreciation and amortization, which in the end give a value of a finished good / product, which will be charged to the income statement once the product has been sold. Sales come into play only once the product has been sold, and therefore has nothing to do with the inventory days formula.
Deduct the value of fixed assets held for sale from the inventory value
Companies often include the value of fixed assets held for sale within its inventory figure. Therefore, it makes sense to read the note relating to inventories carefully, and deduct any such value, as it will likely distort the inventory days figure.
The income statement preparation method makes a (big) difference
Companies prepare their income statement either by using the nature of expense method or the cost of sales method. Both methods lead to identical results, as income and expenses differ by the same amount, however, the difference is in the structure of the income statement report and the availability of information needed for the calculation of inventory days.
The companies in Croatia normally report under the nature of expense method, meaning you will see the costs split into material costs, labour costs, depreciation and amortization, other operating expenses, etc. This form of the income statement does not show a true COGS, i.e., the costs generated in the production process. Each cost type figure includes costs on a company level, meaning we cannot possibly know from the income statement what is the actual production cost. Thus, we are not able to calculate proper inventory days.
On the other hand, global companies normally report under the cost of sales method. This means that the company will show its true COGS*, and we will be able to calculate proper inventory days. While this may be a better approach for us analysts, unless the company has also provided the cost structure under the nature of expense method, we will not be able to compare the inventory days of companies using different methods to prepare their income statement.
* Note that quality of COGS figure and issues with the practical usage of the COGS figure extend beyond this article
And a small tip – when companies report under the cost of sales method, normally there is no specific line for depreciation and amortization, as these costs are allocated to COGS, SG&A, and other expenses. Still, you can find the depreciation and amortization amount in the cash flow statement, under the non-cash adjustments.
How to calculate inventory days when the COGS figure is not available
It is important to stress that without the proper COGS figure, we are not able to calculate proper inventory days. However, there is a solution which is good enough, and which can at least give us an indication of the time a company needs to convert its inventories into receivables.
So, how do we do it?
The inventory part of the inventory days formula stays the same, as regardless of the income statement reporting method, inventories must always include all costs related to the production process.
The more challenging part of the formula are the COGS. This is how we calculate it:
COGS* = Material costs (excl. other external costs) +/- Changes in inventories of finished goods and work in progress
* The formula above excludes other external costs, as in our experience, the costs reported under this line more often than not include costs which are akin to OPEX, i.e., not related to manufacturing costs. Unfortunately, companies’ disclosures are often not detailed enough to properly assess the cost structure.
Changes in inventories of finished goods and work in progress should normally depict the over- / under absorption of production overheads.
Regardless of the formula you choose to calculate COGS, it is important to make sure that the selected formula is consistently applied, especially when comparing performance of various companies.