Rising inventory costs (inflation) or declining inventory costs (deflation) can have a significant impact on a company's financial statements, depending on the inventory valuation method that is used.

Differences in the valuation method selected can affect comparability between companies, when doing financial ratio analysis.

Impact of Inflation

During periods of rising prices and stable or growing inventories:

• COGS and Income. Since LIFO allocates the most recent purchase prices to COGS, the use of LIFO results in higher COGS and lower reported income. In contrast, FIFO allocates the earliest purchase prices to COGS, resulting in lower COGS and higher income.

• Cash Flows. The choice of LIFO vs. FIFO has no effect on pretax cash flows. The pretax cash flow is determined by the cash inflow from sales and cash outflow for purchases, neither of which is affected by the method of inventory accounting. However, the choice of LIFO vs. FIFO affects tax payments. In the U.S., the IRS requires the same inventory methods for financial reporting and tax reporting. Since LIFO generates lower pretax income (when prices are rising), it will result in lower tax payments and, therefore, higher after-tax cash flows than FIFO.

• Working Capital. Working capital is defined as current assets less current liabilities. Since LIFO reports lower inventory than FIFO, working capital will be lower under LIFO.

• Profitability. Profit margin = net income / sales. Sales are not affected by the choice of LIFO or FIFO. Since FIFO results in lower COGS and, therefore, higher net income, profit margins will be higher under FIFO. The net income provided by LIFO is more useful and the lower profit margins reported under LIFO should be used in analysis.

• Liquidity. Current ratio = current assets / current liabilities. Current liabilities are not affected by the choice of FIFO or LIFO. Since LIFO results in lower inventory and, therefore, lower current assets, the current ratio will be lower under LIFO. However, since the inventory provided by FIFO is more useful, the higher current ratio reported under FIFO is better for analytical purposes.

• Activity. Inventory turnover = COGS / average inventory. LIFO provides the more useful COGS while FIFO provides the more useful inventory measure. For analytical purposes, a current cost inventory turnover should be computed using LIFO-basis COGS and FIFO-basis inventory: Inventory Turnover (Current Cost) = COGS (LIFO) / Average Inventory (FIFO).

• Solvency. Debt-to-equity ratio = long-term debt/equity. The choice of LIFO or FIFO has no impact on debt. Since FIFO results in higher inventory values, it reports higher equity, so as to reconcile the balance sheet. Therefore, the debt-to-equity ratio will be lower under FIFO. The lower debt-to-equity ratio reported under FIFO should be used in analysis.
  However, a firm that uses FIFO usually does not disclose its equity under FIFO. In this case, the equity under FIFO can be approximated by adding the LIFO reserve to the equity under LIFO: Equity under FIFO = Equity under LIFO + LIFO reserve. Note that the LIFO reserve is not adjusted for taxes because the tax effect would be insignificant during periods of rising prices and stable or growing inventories.

Impact of Deflation

Whenever inventory unit costs decline and inventory quantities either remain constant or increase, FIFO allocates a higher amount of the total cost of goods available for sale to the cost of sales on the income statement and a lower amount to ending inventory on the balance sheet. A company's gross profit, operating profit, and income before taxes will, therefore, be lower.

LIFO vs FIFO

The ending inventory amount under FIFO will more closely reflect current replacement values because inventories are assumed to consist of the most recently purchased items.

The cost of sales under LIFO will more closely reflect current replacement values.

The LIFO ending inventory amounts are typically not reflective of the current replacement value because the ending inventory is assumed to be the oldest inventory and costs are allocated accordingly.

The general guideline is to use LIFO-based numbers for components that are income-related and FIFO-based data for components that are balance-sheet-related. Ideally, firms could have used FIFO to prepare the balance sheet and LIFO to prepare the income statement. In reality this "perfect" combination is not permitted by accounting rules. Analysts should adjust financial statements between FIFO and LIFO to suit their analytic purposes.