- CFA Exams
- CFA Level I Exam
- Topic 4. Financial Statement Analysis
- Learning Module 6. Analysis of Inventories
- Subject 2. The Effects of Inflation and Deflation on Inventories, COGS and Gross Margin
CFA Practice Question
Which of the following is true in periods of rising prices?
B. Cash flows under FIFO will be better than under LIFO.
C. Cash flows will be the same under FIFO and LIFO.
A. Working capital under FIFO will appear to be better than under LIFO.
B. Cash flows under FIFO will be better than under LIFO.
C. Cash flows will be the same under FIFO and LIFO.
Correct Answer: A
The inventory under FIFO will be much higher than the inventory under LIFO. While cash flows will be lower (due to the tax differences), the effect on the inventory is usually greater; thus working capital under FIFO will appear to be better even though cash flows under LIFO are better.
User Contributed Comments 8
| User | Comment |
|---|---|
| stranger | Higher inventory under FIFO means lower Cash Flow means Better Working Capital and vice versa |
| dlo1 | Cash flows should also be the same under LIFO and FIFO, excluding tax considerations. |
| kutta2102 | I don't know what is implied by "appear to be better" - I thought that in a scenario of rising prices, the LIFO inventory does not reflect true cost of replacement. Therefore, working capital, measured as current assets - current liabilities would "appear" to be better but in fact will not be. |
| JHeld | Just read it one more time, i think you'll get it. |
| YOUCANDOIT | When prices are rising, FIFO => inventory is overstated, COGS is understated, Net income is overstated, leading to higher taxes paid and hence, a lower cash flow results. Working capital (CA-CL) appears better since ending amount of inventory will be higher. |
| Paulvw | I understand the intent of the question, but higher Working Capital is not "better". It's expensive, reduces asset turnover, reduces ROA, requires investment during expansion, can introduce volatility to NI when prices change etc etc. There are parallels in JIT, for example, which has a principle of reducing inventory. Best to stick with saying that Inventory will be higher. |
| johntan1979 | Wow, CA>CL is not better than CA<CL? |
| Inaganti6 | How is CA > CL better ? I thought an excess of CA over CL meant inefficiency in usage of current assets. |