CFA Level 1 - Assets
A company's choice of inventory accounting will affect the company's income, cash flow and balance sheet.
- Income effect - Inventory and cost of goods sold are interdependent. As a result, if LIFO method is used in a rising-price and increasing-inventory environment, more of the higher-cost goods (last ones in) will be accounted for in COGS as opposed to FIFO. Under this scenario, net income will be lower compared to a company that used FIFO accounting.
- Cash flow effect - If we lived in a tax-free world, there would be no cash flow difference between inventory-accounting methods. Unfortunately, we do pay taxes. As a result, if a company uses the FIFO method in a rising-price and increasing-inventory environment, it will have to generate a lower COGS and a higher net taxable income, and pay higher taxes. Tax expenses are a real cash expense and lower a company's cash flow.
- Working Capital - Working capital is defined as current assets minus current liabilities. If one method produces a higher inventory value in the income statement, the working capital will increase.
Table 8.1 Summary of effects given a rising-prices environment and stable or increasing inventories
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The Effects of the Inventory Method On Ratios
Since the accounting method used to account for inventory has an effect on the income statement, balance sheet and cash flow statement, it will ultimately have an effect on the ratios used to measure and compare a company's profitability, liquidity, activity and solvency. While temporary, any significant changes in ratios can have effects on the company’s stock price. While analysts may recognize that the changes in the ratios are sourced from the methods, in the world of rapid information dissemination, traders and investors often react before the news is fully digested.
This is a table that is important to commit to memory. Keep in mind, one method is not necessarily better than the other and often reverse during the next reporting periods so the effects are dynamic in nature.
Computing Profitability Effects
As a general rule, in a rising-price and stable- or increasing-inventory environment,using profitability measures based on LIFO is better. In a rising-price and stable- or increasing-inventory environment,LIFO will have a higher COGS, but it will also be more representative of the current economic reality. As a result, profitability will be more accurate, and a better indicator of future profitability. FIFO will use the cost of the old stock to determine the COGS, making the profitability ratio less reflective of the current economic reality.
As a general rule, in a rising-price and stable- or increasing-inventory environment,using profitability measures based on LIFO is better. In a rising-price and stable- or increasing-inventory environment,LIFO will have a higher COGS, but it will also be more representative of the current economic reality. As a result, profitability will be more accurate, and a better indicator of future profitability. FIFO will use the cost of the old stock to determine the COGS, making the profitability ratio less reflective of the current economic reality.
Most questions relating to the differences under LIFO and FIFO will include a descriptive effect on financial ratios. Students need to understand what each ratio is composed of. |
Before starting this section remember what changes:
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Liquidity Ratio Changes
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From an analytical perspective, in a rising-price and stable- or increasing-inventory environment, it is better to use FIFO liquidity ratios because the LIFO ending inventory is composed of older, cheaper inventory. |
Activity ratios
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From an analytical perspective, in a rising-price and stable- or increasing-inventory environment, the LIFO inventory turnover ratio will trend higher. On the other hand, if we use FIFO, the COGS does not represent the current economic reality. In this case the best thing to do is to use the COGS found under LIFO and divide it by the average inventory found in FIFO. This is called "current-cost method".
From an analytical perspective, in a rising-price and stable- or increasing-inventory environment, it is better to use FIFO total asset turnover ratios because LIFO ending inventory is the older, cheaper inventory. |
Solvency ratios
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From an analytical perspective, in a rising-price and stable- or increasing-inventory environment, it is better to use LIFO debt-to-equity ratio because the retained earnings are more representative of the current economic reality. For the time, interest-earned ratio is more relevant to use LIFO because EBIT will be lower and more representative of future interest-coverage protection. If the company is currently using FIFO, it is better they use the CFO generated by FIFO because the company cannot change the fact that it will have to continue paying higher taxes under this method.
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