Analyze and Compare the Financial Statements of Companies

A company’s choice of inventory valuation method can have a significant impact on the presentation of its financial statements. Financial items such as cost of sales, gross profit, net income, inventories, current assets, and total assets as well as the financial ratios computed from them, will be impacted.

It is therefore very important that consideration is given to these factors when analyzing and comparing the financial statements of companies that rely on different inventory methods. For example, a restatement from the LIFO method to the FIFO method is critical for making a valid comparison between a company that uses the LIFO method and another that uses a method other than the LIFO method.

Analysis and Comparison of Financial Statements of Companies Which Use Different Inventory Methods

To illustrate the analysis and comparison of the financial statements of companies that use different inventory methods, an example will suffice.

Example:

The following comparative information is provided for companies A and B, wherein company A uses the LIFO method, while company B uses the FIFO method for valuing inventories:

$$\begin{array}[t]{l|r|r}
\text{} & \textbf{Company A (LIFO)} & \textbf{Company B (FIFO)} \\
\hline
\text{Inventory} & \text{\$256,000} & \text{\$302,000} \\
\text{Total Assets} & \text{\$1,452,356} & \text{\$1,345,000} \\
\hline
\text{Financial Ratios} & \text{} & \text{} \\
\hline
\text{Inventory Turnover Ratio} & \text{4.73} & \text{3.12} \\
\text{Days of Inventory on Hand} & \text{76 Days} & \text{115 Days} \\
\text{Gross Profit Margin} & \text{19.18%} & \text{20.24%} \\
\text{Return on Assets} & \text{4.78%} & \text{5.36%} \\
\text{Current Ratio} & \text{1.14} & \text{1.30} \\
\hline
\text{Other Indicators} & \text{} & \text{} \\
\hline
\text{Inventory to Total Assets} & \text{17.63%} & \text{22.45%} \\
\begin{array}{l} \text{Growth Rate in Finished} \\ \text{Goods Inventory} \end{array} & \text{30.35%} & \text{39.24%} \\
\text{Growth Rate in Sales} & \text{13.98%} & \text{7.82%} \\
\end{array}
$$

Analysis

• Company A has a lower percentage of assets tied up in inventory than company B. Company B’s higher inventory level suggests that it may be building up slow-moving or obsolete inventories that could result in future inventory write-offs. It may also have higher maintenance costs associated with its inventory than company A.
• Company A has a higher inventory turnover ratio and fewer days of inventory on hand than company B. This suggests that company A is more efficient and effective in managing its inventories.
• Company B, however, appears to be more profitable than company A based on its higher gross profit margin and return on assets. It also seems to be in a better liquidity position based on its higher current ratio.
• Both company A and B’s growth rate in finished goods inventory exceed the growth rate in sales. This could be indicative of an accumulation of excess inventory.

Question 1

If company ABC’s inventory turnover ratio is 4.12 while company XYZ’s inventory turnover ratio is 3.05, which of the following statements is most accurate?

1. Companies ABC and XYZ are equally profitable.
2. Company ABC may be less effective at inventory management than company XYZ.
3. Company ABC may be more effective at inventory management than company XYZ.

Solution

The correct answer is C.

By virtue of company ABC having a higher inventory turnover ratio, it appears to be more effective at inventory management than company XYZ. This makes option B incorrect.

Option A is incorrect also because the conclusion that both companies are equally profitable cannot be drawn from the information provided.

Question 2

An increase in a company’s gross profit margin most likely indicates:

1. An increase in sales.
2. Better inventory management.
3. A decrease in the cost of goods sold.

Solution

The correct answer is C.

$$\text{Gross profit margin} = \frac{\text{(Sales – COGS)}}{\text{Sales}}$$

Better inventory management could decrease inventory, but that would neither affect sales nor the cost of sales. The increase of sales only wouldn’t affect the gross profit margin, since both the numerator and the denominator would increase simultaneously.

The decrease in cost of goods sold would increase the numerator which would eventually increase the whole margin.