Assets - Inventory Analysis

Computing Inventory Balances
In computing ending inventory balances under the various methods we will use the following example.

Example:

Company ABC purchased these items in May, and sold item 102 and 103 for a total of $300:

1. Average-cost method - Under this inventory method the units in inventory are considered as a whole and their cost is averaged out. Companies that use this method carry large amount of units.

Total cost: $130
Average cost: $33 per unit (total cost / total number of units)
Cost of goods sold: $66 ($33*2 units sold)
Ending inventory: $66 ($33*2 units left)
Gross profit: $300-$66 = $234

2. First in first out - Under this inventory method, the units that were first purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 101 and 102)
Ending inventory: $65 (ID: 103 and 104)
Gross profit: $300-$65 = $235

3. Last in first out - Under this inventory method the units that were last purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 103 and 104)
Ending inventory: $65 (ID: 101 and 102)
Gross profit: $300-$65 = $235

Usefulness of Inventory Data When Prices Are Stable or Changing
If the cost of purchasing inventory remains stable, the method used to calculate the cost of goods sold (by FIFO, LIFO or average cost) will yield similar results. On the other hand, in a changing environment this can distort the reported income, cash flow and inventory.

I. Rising Price (Inflationary) Environment

FIFO method

  • COGS will be understated.
  • Income will be overstated.
  • The company will pay more income tax and have a lower cash flow.
  • Assets on the balance sheet will be more reflective of the actual market value.
  • Working capital and current ratio will be increased.
  • Inventory turnover (COGS / average inventory) will worsen (decrease).

LIFO method

  • COGS will be more reflective of current market environment.
  • Income will be lower.
  • The company will pay less income tax and cash flow will be higher.
  • Assets will be understated and not reflective of its market value.
  • Working capital and current ratio will be decreased.
  • Inventory turnover (COGS / average inventory) will improve (increase).

Average-cost method

  • Since it's an average, it would be in between LIFO and FIFO.

II. Decreasing Price (Deflation) Environment

FIFO method

  • COGS will be more reflective of current market environment.
  • Income will be lower.
  • The company will pay less income tax, and cash flow would be higher.
  • Assets will be understated and not reflective of its market value.
  • Working capital and current ratio will be decreased.
  • Inventory turnover (COGS / average inventory) will improve (increase).

LIFO method

  • COGS will be understated.
  • Income will be overstated.
  • The company will pay more income tax and have a lower cash flow.
  • Assets on the balance sheet will be more reflective of the actual market value.
  • Working capital and current ratio will be increased.
  • Inventory turnover (COGS / average inventory) will worsen (decrease).
Look Out!

Make sure you understand this concept very well. It can make or break an entire sample set if you reverse the effects conceptually

Analysts should be aware that companies that operate in a rising-price environment and utilize the LIFO method could manipulate their earnings. To manipulate the earnings management could simply stop purchasing new inventory and start dipping into their old and cheap inventory. This is call "LIFO liquidation".

Most U.S. companies use LIFO as opposed to FIFO. Given the fact that the U.S. has seen cost of inventory rise over the last 30 years (inflation) these companies were able to save on taxes. One should know that the Internal Revenue Service (IRS) does not allow companies to report LIFO for tax purposes and then FIFO on their general-purpose statements.

Analyzing the Financial Statements of Companies That Use Different Inventory Accounting Methods
When comparing two companies, one must ensure that they are comparing apples with apples. If the first company uses the FIFO method and the other the LIFO method, then there is a problem. To make the comparison relevant, one must convert LIFO to FIFO or FIFO to LIFO.

Converting LIFO to FIFO
Related Articles
  1. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  2. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  3. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  4. Professionals

    How To Make Money Using Tobin's Q Ratio

    Although it seems simple, Tobin's Q Ratio is more complex than it appears. We explore some of its main strengths and weaknesses.
  5. Taxes

    3 Secrets You Didn't Know About Estate Planning

    Every advisor and saver needs to know these three estate planning secrets.
  6. Professionals

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  7. Entrepreneurship

    10 Ways to Nurse Cash Flow in Healthcare

    Running a business in healthcare? You might want to rethink cash flow management practices.
  8. Professionals

    How to Help Clients with Cash Flow Issues

    Sometimes your spending gets out of hand or income has a hiccup. Here's how financial advisors can help clients who have cash flow issues.
  9. Professionals

    How to Improve Your Cash Flow in Manufacturing

    Here are 10 ways to to improve a manufacturer's cash flow.
  10. Professionals

    10 Ways to Improve Cash Flow in Construction

    Improving cash flow in construction requires some sector-specific strategies.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!