Sunday, April 5, 2015

Inventory Valuation For Investors: FIFO And LIFO

Are you one of those investors who doesn't look at how company accounts for its inventory? For many companies, inventory represents large (if not largest) portion of assets and, as such, makes up important part of balance sheet, It is, therefore, crucial for investors who are analyzing stocks to understand how inventory îs valued, (In times of economic distress & reduction în consumer spending, businesses always look for ways to increase profits, find out more, în Inventory Valuation

What îs Inventory? 
Inventory îs defined as assets that are intended for sale, are în process of being produced for sale - are to be used în producing goods,

The following equation expresses how company's inventory îs determined:
Beginning Inventory + Net Purchases - Cost of Goods Sold (COGS) = Ending Inventory

In other words, you take what the company has în beginning, add what it has purchased, subtract what's been sold, & result îs what remains,

How do We Value Inventory?
The accounting method that company decides to use to determine costs of inventory can directly impact balance sheet, income statement & statement of cash flow, There are three inventory-costing methods that are widely used by both public & private companies:

FIRST-IN-FIRST-OUT (FIFO)

This method assumes that first unit making its way into inventory îs first sold, For example, let's say that bakery produces 200 loaves of bread on Monday at cost of $1 each, & 200 more on Tuesday at $1,25 each, FIFO states that if bakery sold 200 loaves on Wednesday, the COGS îs $1 per loaf (recorded on income statement) because that was cost of each of first loaves in inventory, The $1,25 loaves would be allocated to ending inventory (appears on balance sheet),

LAST-IN-FIRST-OUT(LIFO)

This method assumes that last unit making its way into inventory îs sold first, The older inventory, therefore, is left over at end of accounting period, For 200 loaves sold on Wednesday, same bakery would assign $1,25 per loaf to COGS, while remaining $1 loaves would be used to calculate value of inventory at end of period,

AVERAGE COST

This method îs quite straightforward; it takes the weighted cost of all units available for sale during accounting period & then uses that average cost to determine value of COGS & ending inventory, In our bakery example, average cost for inventory would be $1,125 per unit, calculated as [(200 x $1) + (200 x $1,25)]/400,
An important point în examples above îs that COGS appears on income statement, while ending inventory appears on balance sheet under current assets,

Why îs Inventory Important?

If inflation were nonexistent, then all three of inventory valuation methods would produce exact same results, When prices are stable, our bakery would be able to produce all of its loafs of bread at $1, & FIFO, LIFO & average cost would give us cost of $1 per loaf,

Unfortunately, world îs more complicated, Over long term, prices tend to rise, which means choice of accounting method can dramatically affect valuation ratios,

If prices are rising, each of accounting methods produce following results:
FIFO gives us better indication of value of ending inventory (on balance sheet), but it also increases net income because inventory that might be several years old îs used to value cost of goods sold, Increasing net income sounds good, but remember that it also has potential to increase amount of taxes that company must pay,
LIFO isn't good indicator of ending inventory value because leftover inventory might be extremely old and, perhaps, obsolete, This results în valuation that îs much lower than today's prices, LIFO results în lower net income because cost of goods sold îs higher,
Average cost produces results that fall somewhere between FIFO & LIFO,
(Note: if prices are decreasing, then complete opposite of above îs true,)

One thing to keep în mind îs that companies are prevented from getting best of both worlds, If company uses LIFO valuation when it files taxes, which results în lower taxes when prices are increasing, it then must also use LIFO when it reports financial results to shareholders,

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