FCFF and FCFE Ratios
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Under IFRS, inventories may be measured and carried on the balance sheet at a lower cost and net realizable value. US GAAP, on the other hand, specifies the lower cost or market value inventories. Market value is the current replacement cost subject to upper and lower limits.
The net realizable value is defined as the estimated selling price in the ordinary course of business minus the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale.
The assessment of net realizable value under IFRS is typically done either item by item or by groups of similar or related items. If the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realizable value. In addition, the loss should be recognized as an expense on the income statement. This expense can be included as part of the cost of sales or reported separately.
A new assessment of net realizable value should be made in each subsequent period. Reversal, which is limited to the amount of the original write-down, is required for a subsequent increase in the value of previously written-down inventory. The reversal of any write-down of inventories is recognized as a reduction in the cost of sales.
Although broadly consistent with IFRS, US GAAP prohibits the reversal of write-downs. The market value cannot exceed the net realizable value given that the lower limit is the net realizable value less a normal profit margin.
Under IFRS, whenever the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realizable value. Most importantly, the loss must be recognized as an expense on the income statement.
Analysts need to consider the possibility of an inventory write-down because its impact on a company’s financial statements and ratios could be significant.
Write-downs reduce inventory value, and the loss in value (expense) is generally reflected in the income statement in the cost of goods sold. An inventory write-down will also reduce profit and the inventory carrying on the balance sheet. Consequently, it will hurt profitability, liquidity, and solvency ratios.
For example, net profit margin and gross profit margin will be lower because of a higher cost of sales (assuming that the inventory write-downs are reported as part of the cost of sales).
Activity ratios such as inventory turnover and total asset turnover will be positively affected because the asset base is reduced (due to a decrease in the average inventory balance and the higher cost of sales).
Question #1
If a company values its inventory at the net realizable value, this will most likely:
- Improve the company’s profitability.
- Decrease the company’s inventory turnover.
- Lead to any loss being recognized as an expense on the company’s income statement.
Solution
The correct answer is C.
When a company’s inventory carrying amount is written down to its net realizable value, the loss is recognized as an expense on the income statement.
A and B are incorrect. If a company values its inventory at the net realizable value, its profitability will decrease as its inventory turnover increases.
Question #2
To find the net realizable value of a company’s inventory, which of the following items ought to be deducted from the inventory’s expected selling price?
- Selling costs.
- Costs required to convert inventory into a sellable condition.
- Both selling costs and costs are required to convert inventory into a sellable condition.
Solution
The correct answer is C.
The net realizable value of a company’s inventory could be figured out using the following equation:
Net realizable value = Selling price in an arm’s length transaction – Cost of sales – Cost required to convert inventory to sellable condition.