Subject 6. Financial Analysis of Inventories

Financial statement disclosures provide information regarding the accounting policies adopted in measuring inventories, the principal uncertainties regarding the use of estimates related to inventories, and details of the inventory carrying amounts and costs. This information can greatly assist analysts in their evaluation of a company's inventory management.

Presentation and Disclosure

Consistency of inventory accounting policy is required under both U.S. GAAP and IFRS. If a company changes an inventory accounting policy, the change must be justifiable and all financial statements accounted for retrospectively. The one exception is for a change to the LIFO method under U.S. GAAP; the change is accounted for prospectively and there is no retrospective adjustment to the financial statements.

Inventory Ratios

Inventory turnover measures how fast a company moves its inventory through the system.

This ratio can be used to measure how well a firm manages its inventories. The lower the ratio, the longer the time between when the good is produced or purchased and when it is sold.

  • An abnormally high inventory turnover and a short processing time could mean either effective inventory management or inadequate inventory, which could lead to outages, backorders, and slow delivery to customers (which would adversely affect sales). Revenue growth should be compared with that of the industry to assess which explanation is more likely.
  • An extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory. Again, the analyst should compare the firm's revenue growth with that of the industry to assess the situation.

Financial Analysis: FIFO versus LIFO

The advantages of LIFO are:

  • Matching. Current costs are matched against revenues and inventory profits are thereby reduced.
  • Tax benefits. These are the major reason why LIFO has become popular. As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs. "Whatever is good for tax is good for financial reporting."
  • Improved cash flow. This is related to tax benefits, because taxes must be paid in cash.
  • Future earnings hedge. With LIFO, a company's future reported earnings will not be affected substantially by future price declines. Since the most recent inventory is sold first, there isn't much ending inventory sitting around at high prices, vulnerable to a price decline.

The disadvantages of LIFO:

  • Reduced earnings. Many managers would just rather have higher reported profits than lower taxes. However, non-LIFO earnings are now highly suspect and may be severely penalized by Wall Street.
  • Inventory understated. LIFO may have a distorting effect on a company's balance sheet. It makes the working capital position of the company appear worse than it really is.
  • Physical flow. LIFO does not approximate the physical flow of the inventory items except in particular situations.
  • Current cost income not measured. LIFO falls short of measuring current cost (replacement cost) income, though not as far as FIFO. Using replacement cost is referred to as the next-in, first-out method; it is not acceptable for purposes of inventory valuation.
  • Inventory liquidation. If the base or layers of old costs are eliminated, strange results can occur, because old, irrelevant costs can be matched against current revenues. The income tax problem is particularly severe when involuntary liquidation results from a strike or a shortage of materials; in these situations, companies may incur high tax bills when they can least afford to pay taxes.
  • Poor buying habits. A company may attempt to manipulate its net income at the end of the year simply by altering its pattern of purchases.

The choice of inventory system or method affects financial numbers. For example, the following is the comparison between LIFO (Last In, First Out) and FIFO (First In, First Out):

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.

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.

User Contributed Comments 7

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sarath: If we use FIFO then ending inventory will cost higher then LIFO ...

so LIFO reserve = FIFO Inventory - LIFO Inventory
tqueiroz: When inflation for a certain period is unknown, a proper measure of inflation can be found dividing the increase in LIFO reserve by beginning-of-year inventory (FIFO basis).
miiyeung: FIFO COGS = LIFO COGS - change in LIFO reserve

FIFO COGS = LIFO COGS - (LIFO reserve END - LIFO reserve Beg)

AND

FIFO Inventory = LIFO Inventory + LIFO reserve
gulfa99: cogs is higher under lifo and lower under fifo
Cashflows are higher under lifo and lower under fifo
rest; higher under fifo and lower under lifo
johntan1979: Thank you miiyeung! Important formulas to remember.
johntan1979: And gulfa99, it's AFTER-TAX cashflows that is higher, not just in general.
Kiniry: Liquidity: The current ratio is lower under LIFO- BUT, the quick ratio will be higher under LIFO because of more cash (from lower taxes.)