~ Professor's Note: The presumption in this section is that prices are rising and
~ inventory quantities are stabfe or increasing.
Since the choice of inveneory accounting method has an impact on income statement and balance sheet items, it will have an impact on ratios as well. In generaLan analyst should use LIFO values when examining profitability or cost ratios and FIFO values when examining asset or equity ratios.
Profitability
Compared co FIFO, LIFO produces COGS balances that are higher and are a better measure of true economic cost. Consequently, we have seen that LIFO produces income values that are lower than FIFO, and LIFO figures are a better measure of future profitabiliry. Profitability ratios, such as gross margin and net profit margin, are lower under LIFO than under FIFO, and ratios calculated using LIFO figures are better for comparison purposes. For firms that use FIFO, income ratios should be recalculated using estimates of what COGS would be under LIFO.
Liquidity
Compared to LIFO, FIFO produces inventory figures that are higher and are a better measure of economic value. LIFO inventory figures use prices that are ourdated and have less relevance co the economic value of inventory. Liquidity ratios, such as the currene ratio, are higher under FIFO [han under LIFO, and ratios calculared using FIFO figures are better for comparison purposes. For firms that use LIFO, liquidity ratios should be recalculated using inventory balances tlut have been resLlted using the LIFO reserve.
©2011S S.:hwc:ser Page 147
SruJ\" Session ')
Cross-Reference to CFA Institute Assigned Reading #35 - Analysis of Inventories
inventory rurnover makes little sense for firms using LIFO due..ro the mismatching of costs (the numerator is largely influenced bycurrent or recent past prices, while the denominator is largely infJuencedby historical prices). Using LIFO when prices are rising causes the inventory rurnover ratio to trend higher even if physical turnover does not change. FIFO-based inventory ratios are relatively unaffected by price changes and are a better approximation of actual turnover. However, the ratio itself can still be misleading because the numeraror does not reflect COGS as well as LIFO accounting does. The preferred method of analysis is to use LIFO COGS and FIFO average inventory. In this way, current COStS are matched in the numerator and denominator.
This method is called the current cost method.
Some firms use an economic order quantity (EOQ) model to determine optimal inventory ordering policies. For these firms, the level of sales will greatly influence inventory rurnover; the lower the sales, the lower the rurnover will be. Some firms are adopting just-in-time inventory policies and keep no inventory (at most, very little) on hand. This results 1n very large inventory rurnover ratios. For these firms, there would be virtually no differences due to the choice between the LIFO and FIFO methods.
LIFO firms tend to carry larger quantities of inventory than comparable FIFO firms.
This can most likely be explained by the tax advantages (i.e., lower taxes dueto higher COGS) of LIFO.
Solvency
FIFO produces higher inventory values that are more relevant than LIFO inventory val ues. To reconcile the balance sheet, stockholders' eq uity must also be adjusted by adding the LIFO reserve. Solvency ratios such as the debt ratio and debt-to-equity ratio will be lower under FIFO because the denominators are larger. For firms that use LIFO, equity, and therefore assets, should be increased byadding the LIFO reserve.
~ Professor's Note: It may seem inconsistent to use LIFO figures for net income and
~ FIFO figures for stockholders' equity. Nonetheless, that isexact~y what an analyst should do.
"'Ex~Plff:"29~vei~il'lg'JJ!r~\~;;*4~iri'
t;t,)~~~'1hm~~~
PartB;''0"Calcu!aterh{'netprofii'iriifgiri,~&freri{'iiti'()"invek;My tiiiif6VEf,ak@""
long-termdebt.,t~-equityratjousingthe<lC:countingfigur~Đãthataremos(
appropriateto comparetoindustr~norms.
Page 148 ©2008Schweser
Study Session 9 Cross-Reference to CFA Institute Assigned Reading#35 - Analysis of Inventories Sample Balance Sheet
Year Assets Cash Receivables Inventories Total current assets
Gross properry, planr, and equipment Accumulated depreciarion
Ner property, plant, and equipment Total assets
Liabilities Payables Shorr-term debr
Current porrion of long-term debt Current liabilities
Long-term debt Deferred taxes Common stock
Addirional paid in capiral Retained earnings
Common shareholders equity Total liabilities and equity Year
Sales
COSt of goods sold Gross profit Operating expenses Operating profir Interest expense Earnings before raxes Taxes
Net income Common dividends
,,-::,.-'.",.-:,,':,-,;...:
,20t)'
2005
$95 195 290 580
$1,700 340 1,360
$1,940
$90 140 45
$275
$690 95 300 400 180 880
$1,940
• Footnote: The company uses rhe LIFO inventory cosr-flow assumprion ro accounr for invenrories. As compared ro FIFO, invenrories would have been
$100 higher in 2006 and $90 higher in 2005.
©2008 Schweser Page 149
Studl' Sc""ioll <)
Cross-Reference to CFA Institute Assigned Reading #35 - Analysis of Inventories
Answer:
Part A:
2005:InvF=InvL+UFO reserve= 290 + 90 = 380 2006: InvF=InvL+UFO reserve=310 + 100 = 410
COGSp=COGSL- (LIFO reserveE- LIFO reserveB) = 3,000 - (1:00-90)=
2,990 Part B:
longl~e~~debt
= equity under FIFO .. long-term debt
=-~~c'----";"----~----
equity under LIFO+UFO reserve
= 610 .... =54.5%
1,02°:1"1.00 .,'
current assets under FIFO
= ,1:urreIrrliabilities
CUITeIltassets under UFO+UFO reserve
=----'-c'---'-..,...
current liabilities
=620+]00=2.2
325 .
debt-to-equity current ratio.
. >COGSurider UFO
lfiventoryturnover=ã . ..•... .
. aver%einv~toryunderFrFO
=. ...3,CJOOj) '::: 7.6
. (38Oc-t-~!.~Pp{
net income under UFO net profit margin ==
sales
== 200 == 5.0%
4,000
When calculating FIFO equity, we have added the entire LIFO reserve without any adjustment for taxes. Note the difference between the questions: What would retained earnings (COGS, net income) have been if the company had used FIFO instead of LIFO? and, How should an analyst adjust retained earnings (assets, equity) for a firm using LIFO to get more meaningful ratios for analysis? In the first case (assuming rising prices), if the firm had used FIFO, then earnings before tax, taxes, net income and retained earnings would all have been higher. In the second case, we are not asking the effects of a different inventory accounting method, but are adjusting ratios to make them more meaningful. The fact that the LIFO firm has an artificially low inventory val ue is corrected by adding the LIFO reserve to both inventory and retained earnings
Page) 50 ©2008Schweser
Study Session 9 Cross-Reference to CFA Institute Assigned Reading#35 - Analysis of Inventories (equity). Unless there is a reason to believe the firm will acrually have a LIFO
liquidation, there is no reason to subtract taxes that have been avoided in adjusting the inventory value, retained earnings, and stOckholders' equity of LIFO firms.