Subject 6. Financial Analysis of Inventories PDF Download
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 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:
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 10
|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)
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.|
|shubhamk0||No adjustments are required in case of price decline since it is normal business situation|
|ravinram||No adjustments required when prices fall. but suppose we are in a period of deflation, and Japan for eg, has been facing the problem of deflation for many years..|
|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.)|
|mali97||Lifo liquidation just went over my head lmao|