Financial Statement Analysis

Analysis of Inventories

Financial Statement Analysis - Book 3

Financial Statement Analysis

Inventory Equation
Beg. inventory + purchases - ending inventory = COGS
Beg. inventory + purchases COGS = ending inventory COGS + ending inventory beg inventory = purchases. COGS + ending inventory purchases = beg inventory Beginning inventory + purchases = ending inventory + COGS
601

LOS 40.a, p. 124

Financial Statement Analysis

Inventory Valuation Methods

FIFO (first in, first out): COGS is first items purchased Ending inventory is last items purchased 1/1 beginning inventory: 2/1purchase: 3/1 purchase: 5 units @ $2/unit = $10 5 units @ $3/unit = $15 5 units @ $4/unit = $20

Example (firm sold 8 units during this period):

COGS (8 units) = (5 $2 + 3 $3) = $19

Ending inventory (7 units) = 5 x $4 + 2 $3 = $26
602

LOS 40.a, p. 124

Financial Statement Analysis

Inventory Valuation Methods cont.

LIFO (last in, first out): COGS is last items purchased Ending inventory is first items purchased

1/1 beginning inventory:

5 units @ $2/unit = $10

2/1 purchase:
3/1 purchase:

5 units @ $3/unit = $15

5 units @ $4/unit = $20

Example (firm sold 8 units during this period):

COGS (8 units) = (5 $4 + 3 $3) = $29

Ending inventory (7 units) = 5 x $2 + 2 $3 = $16
603

LOS 40.a, p. 124

Financial Statement Analysis

Inventory Valuation Methods cont.

Average cost method: both COGS and ending inventory based on average cost
1/1 beginning inventory: 2/1 purchase: 3/1 purchase: 5 units @ $2/unit = $10 5 units @ $3/unit = $15 5 units @ $4/unit = $20

Example (firm sold 8 units during this period): Average cost = ($10 + $15 + $20)/15 units = $3 COGS (8 units) = 8 $3 = $24 Ending inventory (7 units) = 7 $3 = $21
604

LOS 40.a, p. 126

Financial Statement Analysis

Inventory Valuation and Price Changes

When prices are rising (as in the example): (1) COGS LIFO is more useful (reflects current costs) FIFO provides an artificially low value of COGS (2) Ending inventory FIFO is more useful (reflects current costs) LIFO provides an artificially low value of ending inventory.

When prices are declining, the reverse is true With stable prices, all methods result in the same COGS and ending inventory

605

LOS 40.b, p. 128

Financial Statement Analysis

Analyst Adjustments: LIFO to FIFO

LIFO reserve = FIFO inventory LIFO inventory
Inventory FIFO = Inventory LIFO + LIFO reserve

COGS FIFO = COGS LIFO - change in LIFO reserve

COGS FIFO = COGS LIFO (Ending LIFO reserve Beginning LIFO reserve) To estimate COGS LIFO : COGS FIFO + (beginning inventory FIFO inflation)
606

LOS 40.b, p. 128

Financial Statement Analysis

Converting ending inventory and COGS from LIFO to FIFO Sipowitz Company, which uses LIFO, reported end of year inventory balances of 500 in 2005, and $700 in 2006. The LIFO reserve was $200 for 2005 and $300 for 2006. COGS during 2006 was $3000. Convert 2006 ending inventory and COGS to a FIFO basis.

607

LOS 40.b, p. 128

Financial Statement Analysis

Converting ending inventory and COGS from LIFO to FIFO

Inventory FIFO = Inventory LIFO + LIFO reserve

= 700 + 300 = 1000 COGS FIFO = COGS LIFO (Ending LIFO reserve Beginning LIFO reserve). = 3000 (300 200) = 2900
608

LOS 40.b, p. 131

Financial Statement Analysis

Inventory Valuation and Financial Variables

With rising prices and stable/increasing inventories
LIFO results in FIFO results in

Higher COGS
Lower taxes Lower N.I. (EBT & EAT) Lower inventory balances Lower working capital Higher CF (less taxes paid)

Lower COGS
Higher taxes Higher N.I. (EBT & EAT) Higher inventory balances Higher working capital Lower CF (more taxes paid)
609

LOS 40.b, p. 132

Financial Statement Analysis

Profitability Ratios and Inventory Method

Given rising prices, LIFO is a better measure of economic cost; LIFO produces: higher COGS lower income values lower gross margin lower net profit margin

For firms using FIFO, analysts should re-calculate profitability ratios using estimates of LIFO COGS
610

LOS 40.b, p. 132

Financial Statement Analysis

Liquidity Ratios and Inventory Method

When prices are rising, FIFO produces inventory values that are higher and a better measure of current inventory value Given rising prices, FIFO produces higher liquidity ratios (like the current ratio) For firms using LIFO, analysts should recalculate liquidity ratios using estimates of FIFO inventory
611

LOS 40.b, p. 132

Financial Statement Analysis

Activity Ratios and Inventory Method

Inventory turnover ratio (COGS/avg. inventory)

With LIFO, numerator reflects current prices; denominator reflects historical prices: not useful
With FIFO, numerator reflects historical prices; denominator reflects current prices: may be more useful than LIFO Best method: use LIFO COGS and FIFO average inventory (called the current cost method)

612

LOS 40.b, p. 133

Financial Statement Analysis

Solvency Ratios and Inventory Method

FIFO produces a higher value of equity because of the higher inventory value on the left side of the balance sheet; therefore:

Under FIFO, the debt ratio and debt-to-equity ratio are lower (and more meaningful) Under LIFO, analysts should add the LIFO reserve to both inventory and equity to generate more meaningful solvency ratios
613

LOS 40.c, p. 135

Financial Statement Analysis

Reasons for Declining LIFO Reserve

Two reasons that the LIFO reserve may decline over an accounting period are: 1. Inventory quantity is falling (LIFO liquidation)

2. Prices are falling, rather than rising

614

LOS 40.d, p. 135

Financial Statement Analysis

Cost, Market, Net Realizable Value

Inventories are carried at the lower of cost or market (LCM), where cost depends on inventory accounting method chosen Market is generally taken to be replacement cost, but

cannot be greater than net realizable value cannot be less than net realizable value minus a normal profit margin
615

Financial Statement Analysis

Reading 35: Analysis of Inventories

616

Financial Statement Analysis

1-Sweet Milk Inc uses the last in, first out (LIFO) inventory method and had 5,000 units of beginning inventory on January 1, 2002, that was valued at $10.00 a unit. The company purchased 50,000 units at $12 a unit and sold 52,000 units at $15 a unit. Sweet Milk is considering an additional purchase of 10,000 units at $13 a unit. The company will make the purchase at the end of December or in the early part of year 2003. Which statement about the effect of the purchase decision on net income is most accurate? A) Postponing the purchase until January will increase income for 2002 by $14,000. Making the purchase in December will increase income by $16,000 in year 2002. Income for year 2002 will not be affected no matter when the inventory is purchased. Postponing the purchase until January will decrease income for year 2002 by $15,000. 617

B)

C)

D)

Financial Statement Analysis By postponing the purchase until January, cost of goods sold (COGS) would be $620,000. A purchase in December would increase COGS to $634,000.

COGS for January purchase = (50,000 12) + (2,000 10) = 620,000 COGS for December purchase = (10,000 13) + (42,000 12) = 634,000

618

Financial Statement Analysis 2-Given the following inventory data about a firm: Beginning inventory 20 units at $50/unit Purchased 10 units at $45/unit Purchased 35 units at $55/unit Purchased 20 units at $65/unit Sold 60 units at $80/unit

What is the inventory value at the end of the period using LIFO? A) B) C) D) $1,575. $3,450. $1,225. $1,375.
619

Financial Statement Analysis Ending inventory equals 20 + 10 + 35 + 20 60 = 25 of the first units purchased equals:

(20 units)($50/unit) + (5 units)($45/unit) = $1,000 + $225 = $1,225

620

Financial Statement Analysis 3-In 2004, Torrence Co. had a beginning inventory of $19,924 and made purchases of $15,923. If the ending inventory level was $19,204, what was the cost of goods sold (COGS) for year 2004? A) B) C) D) $15,923. $16,643. $15,203. $720.

621

Financial Statement Analysis Beginning Inventory + Purchases Ending Inventory = COGS. $19,924 + $15,923 $19,204 = $16,643.

622

Financial Statement Analysis 4-Which of the following is least likely part of the basic inventory equation? A) Beginning inventory + purchases = ending inventory + cost of goods sold. Purchases ending inventory + beginning inventory = cost of goods sold. Beginning inventory + purchases cost of goods sold = ending inventory. Beginning inventory ending inventory cost of goods sold = purchases.

B)

C)

D)

623

Financial Statement Analysis To solve for purchases the basic inventory equation would then be: ending inventory + COGS beginning inventory = purchases

624

Financial Statement Analysis 5-A company's beginning inventory was overstated by $3,000, now ending inventory is understated by $2,000. If purchases were properly reported, then earnings before taxes will be:

A)
B) C) D)

understated by $5,000.
overstated by $5,000. understated by $1,000. overstated by $1,000.

625

Financial Statement Analysis Cost of goods sold (COGS) will be overstated by 5,000 so earnings before taxes (EBT) will be understated by 5,000.

626

Financial Statement Analysis 6-The Mountain Bike Supply Company had 500 units in its beginning inventory. Each of these units cost $5. During the period, Mountain Bike Supply first purchased 400 units at $6 each and then 200 units at $7 each. At the end of the period, Mountain Bike Supply had 600 units. What is the cost of goods sold and inventory for Mountain Bike Supply if it uses FIFO inventory valuation? COGS $2,500 $2,500 $3,200 $3,200 Inventory $3,800 $3,100 $3,800 $3,100

A)
B) C) D)

627

Financial Statement Analysis Under FIFO:

COGS = 500 @ $5 = $2,500

Inventory = 200 @ $7 + 400 @ $6 = $3,800

628

Financial Statement Analysis

7Purchases 20 units at $50 35 units at $40 85 units at $30

Sales 15 units at $60 35 units at $45 85 units at $35

Assume beginning inventory was zero. Inventory value at the end of the period using the average cost method is: A) B) $1,540. $177.

C)
D)

$2,100.
$4,680.
629

Financial Statement Analysis Average Cost = Cost of Goods Available / Total Units Available

Average Cost = $4,950 / 140 = $35.36

EOP Inventory Value = $35.36 x 5 = $176.79

630

Financial Statement Analysis 8-Inventory value at the end of the period using FIFO is: A) B) C) $1,200. $175. $150.

D)

$6,000.

631

Financial Statement Analysis

Inventory value at the end of the period using FIFO is:

5 x 30 = 150

632

Financial Statement Analysis 9-Inventory value at the end of the period using LIFO is: A) B) C) $1,200. $250. $2,100.

D)

$2,400.

633

Financial Statement Analysis 5 x $50 = $250

634

Financial Statement Analysis

10-An analyst notes the following about a company: Beginning inventory was reported as $5,000. Costs of goods sold were reported as $8,000. Ending inventory is $7,000 (the analyst has physically verified his amount). Which of the following statements is most accurate? A) If the analyst discovered that beginning inventory was understated by $2,000, then earnings before taxes must have been overstated by $2,000. If the analyst discovered that beginning inventory was overstated by $1,000, then cost of goods sold must have been understated by $1,000. Purchases must have been $6,000. Assuming a tax rate of 35%, the firm's net income would be $700.
635

B)

C) D)

Financial Statement Analysis If inventory is overstated then COGS must also be overstated or purchases were understated, since you are told that ending inventory is ok.

636

Financial Statement Analysis 11-A firms financial statements reflect the following information: Beginning inventory $2,900,000 Purchase during the year $1,600,000 Ending inventory ? Sales $3,900,000 Gross Margin 0.41 What was the firms ending inventory for this period? A) B) C) D) $2,799,000. $1,699,000. $3,199,000. $2,199,000.
637

Financial Statement Analysis COGS = Sales (1 gross marging) COGS = 3 900 000 ( 1 0.41 ) COGS = 2 145 000 Beginning inventory + Purchases - COGS Ending inventory $ 2 900 000 1 600 000 2 145 000 $ 2 199 000

638

Financial Statement Analysis 12-A firms financial statements reflect the following information: Beginning inventory $3,200,000 Purchase during the year $1,700,000 Ending inventory $2,100,000 Sales $4,800,000 Gross profit margin ? What was the firms gross profit margin? A) B) C) D) 2.29. 0.58. 0.42. 1.93.

639

Financial Statement Analysis

Beginning inventory + Purchase during the year - Ending inventory COGS Sales COGS Profit margin

$3,200,000 1,700,000 2,100,000 $ 2,800,000

$4,800,000 2,800,000 2,000,000

Gross profit margin = 2,000,000 / 4,800,000 = 0.42

640

Financial Statement Analysis 13-Which of the following inventory accounting methods must be used for financial reporting purposes if a U.S. firm uses last in, first out (LIFO) for tax purposes?

A)
B) C) D)

FIFO.
Average cost. The firm may use any of the above methods. LIFO.

641

Financial Statement Analysis If a U.S. firm uses LIFO for tax purposes, it must also use LIFO for financial reporting purposes, according to U.S. tax law.

642

Financial Statement Analysis 14-Pischke Motors provided you with the following financials: Beginning LIFO reserve $2,484 Cost of goods sold (COGS) using LIFO $3,988 COGS using FIFO $2,004 What is the ending LIFO reserve? A) B) C) $500. $4,468. $2,484.

D)

$1,984.

643

Financial Statement Analysis

Ending LIFO reserve = (LIFO COGS FIFO COGS) + Beginning LIFO reserve = ($3,988 $2,004) + $2,484

= $4,468

644

Financial Statement Analysis 15-LIFO liquidation may result when: A) B) C) purchases are less than goods sold. purchases are more than goods sold. purchases are equal to the goods sold.

D)

cost of goods sold is less than the available inventory.

645

Financial Statement Analysis For LIFO companies, when more goods are sold than are purchased during a period, the goods held in opening inventory are in included in COGS. This will result in LIFO liquidation.

646

Financial Statement Analysis 16-In case of a decline in LIFO reserve, to obtain a better analysis an analyst should: A) adjust the income statement, only if such a decline is due to falling prices. adjust the income statement, regardless of the reasons for the decline. not make any adjustments. adjust the income statement, only if such a decline is due to LIFO liquidation.

B)

C) D)

647

Financial Statement Analysis

A decline in LIFO reserve is due to either falling prices or LIFO liquidations. The response of the analyst should not be the same in both cases. In the case of LIFO liquidation, the income statement does not reflect the current costs and should be adjusted. In the case of falling prices, the LIFO income statement amounts are current and do not need adjustment.

648

Financial Statement Analysis 17-In a period of rising prices, LIFO liquidation results in: A) B) C) D) lower earnings. increase in inventory. higher earnings. increase in accounts receivable.

649

Financial Statement Analysis

Since older layers of inventory that are liquidated were purchased at lower prices, the cost of goods sold will be lower and earnings will be higher.

650

Financial Statement Analysis 18-The best way to compute an inventory turnover ratio is to use: A) last in, first out (LIFO) for cost of goods sold (COGS) and first in, first out (FIFO) for average inventory. first in, first out (FIFO) for both cost of goods sold (COGS) and average inventory. last in, first out (LIFO) for both cost of goods sold (COGS) and average inventory. first in, first out (FIFO) for cost of goods sold (COGS) and last in, first out (LIFO) for average inventory.

B)

C)

D)

651

Financial Statement Analysis Inventory turnover makes no sense at all for firms using LIFO due to the mismatching of costs (the numerator is current while the denominator is historical). FIFO based inventory is relatively unaffected by price changes and is a good approximation of actual turnover. In this way, current costs are matched in the numerator and denominator.

652

Financial Statement Analysis 19-When analyzing profitability ratios, which inventory accounting method is preferred? A) B) C) D) First in, first out (FIFO). Last in, first out (LIFO). Weighted average. Profitability ratios are not affected by the inventory accounting method used.

653

Financial Statement Analysis

Using LIFO cost of goods sold (COGS) gives a more accurate measure of future earnings because the LIFO COGS is more representative of the current cost of product sold as compared to using FIFO therefore net income will be more accurately represented.

654

Financial Statement Analysis 20-In general, when analyzing profitability and costs, or when analyzing asset and equity ratios, which of the following should be used?

A) B) C) D)

Profitability/Cost Ratios FIFO

FIFO LIFO LIFO

Asset/Equity Ratios LIFO

FIFO FIFO LIFO

655

Financial Statement Analysis

In general, an analyst should use LIFO when examining profitability or cost ratios and FIFO when examining asset or equity ratios.

656

Financial Statement Analysis 21-If a company using last in, first out (LIFO) reports an inventory balance of $22,000 and a LIFO reserve of $4,000, the estimated value for the inventory on a first in, first out (FIFO) basis would be:

A)
B) C) D)

$13,000.
$18,000. $24,000. $26,000.

657

Financial Statement Analysis FIFO INV = LIFO INV + LIFO Reserve

X = 22,000 + 4,000

X = 26,000

658

Financial Statement Analysis 22-The year-end financial statements for a firm using last in first out (LIFO) acounting show an inventory level of $5,000, cost of goods sold (COGS) of $16,000, and inventory purchases of $14,500. If the LIFO reserve is $4,000 at year-end and was $1,500 at the beginning of the year, what would the COGS have been using FIFO accounting? A) B) C) D) $13,500. $18,500. $11,000. $12,000.

659

Financial Statement Analysis

COGS from LIFO to FIFO:

COGSF = COGSL - change in LIFO reserve

= COGSL - (LIFO reserveE - LIFO reserveB) = $16,000 - ($4,000-$1,500) = $16,000 - $2,500 = $13,500

660