Financial Analysis #16 - Inventories: Implications for Financial Statements and Ratios

Question 1

Cost of Goods Solds (COGS) and ending inventory equations

Answer 1

LOS 16.a

COGS = inventory_start + purchases - inventory_end

inventory_end = inventory_start + purchases - COGS

Question 2

cost flow methods

Answer 2

LOS 16.a

IFRS and GAAP approved:

FIFO

WAC

Specific Identification

GAAP only:

LIFO (LIFO conformity rule for US Tax Code states that companies using LIFO for tax purposes must also use LIFO for finanical reporting purposes)

Question 3

LIFO vs. FIFO inventory effects on Financial Statements

(inflation and rising/steady inventory levels):

Inv, W/C, R/E, COGS, EBT, Taxes, NI, CFO

Answer 3

LOS 16.a,c

During Inflationary environments:

LIFO FIFO Adj LIFO to FIFO

BS Inv Lower Higher + LR

BS W/C Lower Higher - tax_LR

BS R/E Lower Higher + LR - tax_LR

BS CA Lower Higher + LR - tax_LR

IS COGS Higher Lower - d(LR)

IS EBT Lower Higher + d(LR)

IS Taxes Lower Higher + tax_d(LR)

IS NI Lower Higher + d(LR) - d(LR)

CF CFO Higher Lower + d(LR) - tax_d(LR)

LR = LIFO Reserve; d(LR) = LIFO Effect

tax_LR = taxes on LIFO Reserve; tax_{d(LR) = taxes on LIFO Effect}

Question 4

Periodic vs. Perpetual Invetory Systems: effects on COGS and Ending Inventory

Answer 4

LOS 16.a

FIFO and Specific ID: no effect

LIFO and WAC: can be significant differences

Question 5

LIFO Reserve (def and equation)

LIFO Effect (def and equation)

Answer 5

LOS 16.b

LIFO Reserve - the difference between LIFO inventory and FIFO Inventory:

LIFO reserve = Inventory_FIFO - Inventory_LIFO

LIFO Effect - the change in LIFO reserve from one period to the next:

LIFO reserve = Inventory_LIFO(t+1) - Inventory_LIFO(t)

Question 6

LIFO to FIFO Adjustments: Effect on Ratios

current ratio, inventory turnover, debt/equity, GI, NI

Answer 6

LOS 16c,e

current ratio (CA/CL): incr (+LR-tax_LR)

inv t’ver: (COGS/avg inv): decr (-d(LR))/+LR

Debt / Equity (LTD/E): decr 1/+LR-tax_LR

GI and NI: incr +d(LR)-tax_d(LR)

Question 7

LIFO Liquidation (def)

Answer 7

LOS 16.b

LIFO Liquidation - occurs when goods sold > goods replaced

e. g. a LIFO firm finally recognizes NI that was deferred by using LIFO inventory method
e. g. a LIFO firm finally uses the older lower cost inventory items

Question 8

Describe the implications of valuing inventory at net realizable value (NRV) for financial statements and ratios (for IFRS and for GAAP)

Answer 8

LOS 16.d

IFRS: inventory is valued at min(cost, NRV), where:

NRV = E(selling price) - E(selling costs)

inventory write-ups are allowed, but only to the extent of a previous write-down

GAAP: inventory is valued at min(cost, market)

market = replacement cost (usually), where:

NRV-normal margin <= market <= NRV

Write-ups are not allowed

Question 9

Explain issues that analysts should consider when examining a firm’s inventory disclosures and other sources of information

Answer 9

LOS 16.f

Compare current to historical inventory data (mfg firm):

+raw mat’l and/or +WIP ⇒ +demand ⇒ +R, +EPS

+FG & -WIP and/or -raw mat’l ⇒ -demand ⇒ -R, -EPS

Compare growth rates:

d(FG) > d(sales) ⇒ -demand ⇒ obsolete inv ⇒ inv write-downs ⇒ -EPS

Also:

Excess inv ⇒ +storage cost, +insurance, +inv tax ⇒ wasted cash