Do you routinely analyze your companies, but don't look at how they account for their inventory? For many companies, inventory represents a large, if not the largest, portion of their assets; as such, inventory is a critical component of the balance sheet. Therefore, it is important that serious investors understand how to assess the inventory line item when comparing companies across industries or in their own portfolios.

### What Is Inventory?

In general, when we speak of inventory, we are referring to a company's goods in three stages of production: 1) goods that are raw materials, 2) goods that are in production, and 3) goods that are finished and ready for sale. In other words, you take the goods that the company has in the beginning, add the materials that it purchased to make more goods, subtract the goods that the company sold, cost of goods sold (COGS), and the result is what remains—inventory.

Inventory accounting assigns values to the goods in each production stage and classifies them as company assets, as inventory can be sold, thus turning it into cash in the near future. Assets need to be accurately valued so that the company as a whole can be accurately valued. The formula for calculating inventory is:

﻿$\textit{Beginning Inventory } + \textit{ Net Purchases } - \textit{ Cost of Goods Sold (COGS)} = \textit{Ending Inventory}$﻿

### Methods of Valuing Inventory—LIFO and FIFO

The accounting method that a company uses to determine its inventory costs can have a direct impact on its key financial statements (financials)—balance sheet, income statement, and statement of cash flows. The U.S. generally accepted accounting principles (GAAP) allow businesses to use one of several inventory accounting methods: first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost.

• 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 (on income statement) is $1 per loaf because that was the cost of each of the first loaves in inventory. The$1.25 loaves would be allocated to ending inventory (on the balance sheet).
• Last-In, First-Out (LIFO): This method assumes that the last unit to arrive in 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.

### LIFO or FIFO? It Really Does Matter

The difference between $8,000,$15,000 and \$11,250 is considerable. In a complete fundamental analysis of ABC Company, we could use these inventory figures to calculate other metrics—factors that expose a company's current financial health, and which enable us to make projections about its future, for example. So, which inventory figure a company starts with when valuing its inventory really does matter. And companies are required by law to state which accounting method they used in their published financials.

Although the ABC Company example above is simple, the subject of inventory and whether to use LIFO, FIFO, or average cost is complex. Knowing how to manage inventory is a critical tool for companies, small or large; as well as a major success factor for any business that holds inventory. Managing inventory can help a company control and forecast its earnings. Conversely, not knowing how to use inventory to its advantage can prevent a company from operating efficiently.