Most businesses produce their revenues by selling either goods or services or some combination of both to their customers. Acquisition costs of goods intended for sale and sold, whether those costs were incurred through purchasing or manufacturing the goods in question, are counted up and listed in each accounting time period as "cost of goods sold." Number of days in inventory ratio is calculated as 365 days divided by the inventory turnover ratio, which can be calculated using either sales or cost of goods sold.
Cost of Goods Sold
Each good that a business intends for sale has an acquisition cost attached to it. For example, if a business purchased a unit for $10, that $10 is that unit's acquisition cost. Alternatively, if a business spent $20 to manufacture the same unit using its own operations, that $20 is likewise that unit's acquisition cost. Since businesses must sell units at a premium to produce a profit, the total acquisition cost of its goods intended for sale that were sold in one period are not the same as its sales revenue for that period.
Inventory Turnover Ratio
Inventory turnover ratio is calculated as either total sales revenue over inventory or cost of goods sold over the average inventory. All four accounts must be of the same time period or the ratio is meaningless. Inventory turnover ratio measures the times that the business's inventory is sold and replaced in one single time period.
Number of Days Inventory Ratio
Number of days inventory ratio is sometimes also called either the average inventory period or the inventory holding period. It is calculated as 365 days divided by the inventory turnover ratio. Number of days inventory ratio measures the number of days' worth of goods intended for sale that the business has on hand.
Implications of Number of Days Inventory Ratio
Too high a number of days inventory ratio means that the business is not selling its inventory very quickly, suggesting that there might not be much demand for its products. In comparison, a low number of days inventory ratio means that the business is selling its inventory quite fast, and too low a ratio might mean that the business isn't replenishing its inventory fast enough to keep up with demand.