Many investors over look on how the companies accounts for its inventory and this is not a good thing on the side of the investors. This is because for most of the companies that are out there, the inventory represents a large portion of the assets. As a result of this it is crucial for the investors who are analyzing the stocks to understand how the inventory is valued as the inventory for that particular company makes up an important part of the balance sheet.
Let’s begin by defining what is inventory. It is basically the assets of the company that is intended for sale. They are the products that are also in the process of being produced for sale or are to be used for producing the goods. Another way of defining inventory can be expressed in the following formula, beginning inventory plus net purchases subtracted by the cost of the goods sold (COGS) equals the ending inventory. So it can basically mean the to get the inventory of that particular company, one would take what the company has starting out, take what was purchased and add that to the equation, after that subtract what was sold and finally the remaining would be the result.
Now that we have established what an inventory is, the other question is how does one evaluate inventory? A particular company will usually use a certain type of accounting method to determine the how the impact of the costs of the inventory will have on the statement of cash flow, balance sheet and income statement. First In First Out (FIFO), Last In First Out (LIFO) and average cost are the three widely used inventory costing methods by both the private companies and the public.
FIFO is an accounting method that assumes that the first unit that has already made its way into the inventory will be the first that is sold. So let’s take for example a bakery that produces 200 pieces of cupcakes on Monday at a cost of RM2 each, and another 200 more on the next day at RM2.50 per cupcake. If one were to use the FIFO method, then it would state that if the bakery sold 200 pieces of cupcake on Wednesday, then the COGS would be RM2 per piece as recorded on the income statement. This is because this was the cost of each of the first cupcakes in the inventory. And the RM2.50 cupcakes would then be allocated to the ending inventory when it appears on the balance sheet.
The next accounting method is LIFO, which is the exact opposite of FIFO, as this type of method assumes that the last unit that makes its way into the inventory is the first that is sold. And after the accounting period the older inventory is left over. So taking the previous example of the bakery and its 200 pieces of cupcakes, let’s say that the 200 pieces of cupcakes were sold on Wednesday, and then the bakery would assign RM2.50 to each piece of cupcake to COGS while the remaining at the end of the period the RM2 cupcakes would be used for calculation of the value of the inventory.
And finally is the average cost and it can be considered as a straightforward method as it takes the weighted average of all the units that is available for sale during the accounting period and then it will use the average cost to determine the COGS value as well as the ending inventory.
Now that you have gotten a better idea about inventory as well as the methods used to calculate it, we will now look at the importance of inventory. The three inventory valuation methods that were explained earlier would have produced the exact same results if there was no such thing as inflation. This is because the accounting cost, FIFO and LIFO would give each of the pieces of cupcakes a cost of RM2 each when the prices are stable and the bakery would be able to produce at the cupcakes at RM2.
This of course is an over simplification of the situation, as we all know the world is a much more complicated place than the scenario that was described earlier. The choice of the accounting method would greatly affect the valuation ratios as time passes the prices will tend to rise. So, if the prices of goods are on the rise, then each of the accounting methods that were mentioned earlier will produce the respective results.
LIFO is not a good indicator of the ending inventory value as the items that are left over in the inventory maybe extremely old and in the worst case scenario it might be obsolete. Due to these circumstances the valuation of the items would be much lower compared to the items of today’s prices. As an outcome of this, as well as the costs of goods being sold higher LIFO will result in lower net income.
As compared to that of FIFO, this particular inventory valuation method will provide a better indication of the value of ending inventory as shown on the balance sheet. However, the FIFO will also cause the net income to increase due to inventory that may be several years old will be used to value the costs of the goods sold. It might sound good at first when the net income has increased but this may also cause the amount of tax the company will be required to pay.
And the result that is produced by the average cost will fall between that of LIFO and FIFO. As there are pros and cons to each of the inventory valuation methods, companies however are prevented from gaining only the pros from each of the accounting methods. This means that if that particular company is using the LIFO valuation when they are filing their taxes, which will result in the lowering of the taxes when the prices are increasing. Then when they are reporting the financial results to the shareholders they must also use LIFO. This however will lower the net income as well as the earnings per share.
As a conclusion many of the companies will state that they will use the lower market or cost, which means that if the inventory values were to decrease dramatically, then the valuations of the product would represent the market value or replace the cost instead of using the LIFO, FIFO or average cost. Things might seem a little complicated at first but you still need to understand the inventory calculation. This is because the next time that you are evaluating a company to see whether or not it is worth investing in, take a look at the company’s inventory, you will be surprised at what information you will get.
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