Are you one of those investors who doesn't look at how a company accounts for its inventory? For many companies, inventory represents a large (if not the largest) portion of assets and, as such, makes up an important part of the balance sheet. It is, therefore, crucial for investors who are analyzing stocks to understand how inventory is valued.

What is Inventory?
Inventory is defined as assets that are intended for sale, are in process of being produced for sale or are to be used in producing goods.

The following equation expresses how a company's inventory is determined:

Beginning Inventory + Net Purchases - Cost of Goods Sold (COGS) = Ending Inventory

In other words, you take what the company has in the beginning, add what it has purchased, subtract what's been sold, and the result is what remains.

How Do We Value Inventory?
The accounting method that a company decides to use to determine its inventory costs can directly impact the balance sheet, income statement and statement of cash flow. Three inventory-costing methods are widely used by both public and private companies:

  • First-In, First-Out (FIFO)
    This method assumes that the first unit making its way into inventory is the first sold. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS is $1 per loaf (recorded on the income statement) because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (appears on the balance sheet).
  • Last-In, First-Out (LIFO)
    This method assumes that the last unit making its way into inventory is sold first. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period.
  • Average Cost
    This method is quite straightforward; it takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.

An important point in the examples above is that COGS appears on the income statement, while ending inventory appears on the balance sheet under current assets.

Why is Inventory Important?
If inflation were nonexistent, then all three of the inventory valuation methods would produce the exact same results. When prices are stable, our bakery would be able to produce all of its bread loaves at $1, and FIFO, LIFO and average cost would give us a cost of $1 per loaf.

Unfortunately, the world is more complicated. Over the long term, prices tend to rise, which means the choice of accounting method can dramatically affect valuation ratios.

If prices are rising, each of the accounting methods produce the following results:

  • FIFO gives us a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value the cost of goods sold. Increasing net income sounds good, but remember that it also has the potential to increase the amount of taxes that a company must pay.
  • LIFO isn't a good indicator of ending inventory value because the leftover inventory might be extremely old and, perhaps, obsolete. This results in a valuation much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher.
  • Average cost produces results that fall somewhere between FIFO and LIFO.

(Note: if prices are decreasing, then the complete opposite of the above is true.)

Keep in mind that companies are prevented from getting the best of both worlds. If a company uses LIFO valuation when it files taxes, which results in lower taxes when prices are increasing, it then must also use LIFO when it reports financial results to shareholders. This lowers net income and, ultimately, earnings per share.

Let's examine Cory's Tequila Co. (CTC) inventory to see how the different inventory valuation methods can affect the financial analysis of a company.

Monthly Inventory Purchases*
Month Units Purchased Cost/ea Total Value
January 1,000 $10 $10,000
February 1,000 $12 $12,000
March 1,000 $15 $15,000
Total 3,000
Beginning Inventory = 1,000 units purchased at $8 each (a total of 4,000 units)
Income Statement (simplified): January-March*
Item LIFO FIFO Average
Sales = 3,000 units @ $20 each $60,000 $60,000 $60,000
Beginning Inventory 8,000 8,000 8,000
Purchases 37,000 37,000 37,000
Ending Inventory (appears on B/S)
*See calculation below
8,000 15,000 11,250
COGS $37,000 $30,000 $33,750
Expenses 10,000 10,000 10,000
Net Income $13,000 $20,000 $16,250

*Note: All calculations assume that there are 1,000 units left for ending inventory:
(4,000 units - 3,000 units sold = 1,000 units left)

What we are doing here is figuring out the ending inventory, the results of which depend on the accounting method, to determine COGS. All we've done is rearrange the above equation into the following:

Beginning Inventory + Net Purchases - Ending Inventory = Cost of Goods Sold
LIFO Ending
Inventory Cost =
1,000 units X $8 each = $8,000
Remember that the last units in are sold first; therefore, we leave the oldest units for ending inventory.
FIFO Ending
Inventory Cost =
1,000 units X $15 each = $15,000
Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory.
Average Cost Ending Inventory = [(1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)]/4000 units = $11.25 per unit
1,000 units X $11.25 each = $11,250
Remember that we take a weighted average of all the units in inventory.

Using the information above, we can calculate various performance and leverage ratios. Let's assume the following:

Assets (not including inventory) $150,000
Current assets (not including inventory) $100,000
Current liabilities $40,000
Total liabilities $50,000

Each inventory valuation method causes the various ratios to produce significantly different results (excluding the effects of income taxes):

Ratio LIFO FIFO Average Cost
Debt-to-Asset 0.32 0.30 0.31
Working Capital 2.7 2.88 2.78
Inventory Turnover 7.5 4.0 5.3
Gross Profit Margin 38% 50% 44%

As you can see from the ratio results, inventory analysis can have a big effect on the bottom line. Unfortunately, a company probably won't publish its entire inventory situation in its financial statements. Companies are required, however, to state in the notes to financial statements what inventory system they use. By learning how these differences work, you will be better able to compare companies within the same industry.

The Bottom Line
Many companies will also state that they use the "lower of cost or market." This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of FIFO, LIFO or average cost.

Understanding inventory calculation might seem overwhelming, but as an investor you need to be aware of it. Next time you're valuing a company, check out its inventory; it might reveal more than you thought.

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