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 which 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 which uses the LIFO method and a company which uses a method other than the LIFO method.
Analysis and Comparison of Financial Statements of Companies which use Different Inventory Methods
The analysis and comparison of the financial statements of companies which use different inventory methods are best explained by an example.
The following comparative information is provided for company A and B, wherein company A uses the LIFO method, while company B uses the FIFO method for valuing inventories:
- 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 which 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 looks 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.
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?
A. Company ABC may be less effective at inventory management than company XYZ.
B. Companies ABC and XYZ are equally profitable
C. Company ABC may be more effective at inventory management than company XYZ.
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 choice A incorrect. Choice B is incorrect also because the conclusion that both companies are equally profitable cannot be drawn from the information provided.
An increase in a company’s gross profit margin most likely indicates:
A. Better inventory management.
B. A decrease in the cost of goods sold.
C. An increase in sales.
The correct answer is B.
Gross profit margin = (Sales – COGS)/Sales
Better inventory management could decrease inventory, but that would affect neither sales nor the cost of sales. The increase of sales only wouldn’t affect the gross profit margin, as 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.
Reading 28 LOS 28l:
Analyze and compare the financial statements of companies, including companies that use different inventory methods