The inventory conversion period is the time required to obtain materials for a product, manufacture it, and sell it. The inventory conversion period is essentially the time period during which a company must invest cash while it converts materials into a sale. The calculation is:
Inventory ÷ (Cost of sales ÷ 365)
Though the inventory conversion period is treated as an average amount for all of the items that a company manufactures, it is most useful when calculated on an individual product basis, since you can then discern which products require the longest period to construct and convert to cash - which can result in process analysis to compress these time periods, thereby reducing the company's cash investment in inventory.
There are two issues that can make the inventory conversion period a somewhat less useful metric:
- The measurement assumes that all items are manufactured in-house. However, if a company elects to outsource production, the inventory conversion period will either shrink dramatically or be reduced to zero, though perhaps at the cost of a reduced gross margin.
- If suppliers agree to very long payment terms, or if the time period to sell to customers is less than the payment terms to suppliers, or if customers pay in advance, then there is effectively no inventory conversion period at all from the perspective of cash flow, since the company is investing no net cash in the process.