INVENTORY VALUATION CAN CHANGE YOUR INVESTING DECISION!

Aug 18 - 24, 2003

Are you one of those investors who don't look at how a company accounts for its inventory? For many companies inventory represents a large (if not the largest) portion of assets. Because inventory represents such a big part of the balance sheet, it is important for investors when analyzing stocks to understand how inventory is valued.

WHAT IS INVENTORY?

Inventory is assets that are intended for sale, are in process of being produced for sale, or are to be used in producing goods.

The following equation expresses how a company's inventory is determined:

Beginning Inventory + Net Purchases - Cost of Good Sold = Ending Inventory

In other words, you take what you have in the beginning, add what you've purchased, subtract what you've sold, and the result is what you have remaining.

HOW DO WE VALUE INVENTORY?

The accounting method that a company decides to use to determine the costs of inventory can directly impact the balance sheet, income statement, and statement of cash flow. There are three inventory-costing methods that are widely used by both public and private companies:

* First-In, First-Out (FIFO) — This method assumes that the first unit making its way into inventory is the first sold. For example, let's say that a bakery produces 200 loafs of bread on Monday at Rs.1 each, and 200 more on Tuesday at Rs.1.25 each. FIFO states that if the bakery sold 200 loafs on Wednesday, the cost of goods sold is Rs.1 per loaf because that was the cost of each the first loafs into inventory. The Rs.1.25 loafs would be allocated to ending inventory (appears on the balance sheet).

* Last-In, First-Out (LIFO) — This method assumes that the last unit making its way into inventory is sold first. The outdated inventory is therefore left over at the end of the accounting period. For the 200 loafs sold on Wednesday, the same bakery company would allocate Rs 1.25 to cost of goods sold while the remaining Rs 1 loafs would be used to calculate the value of inventory at the end of the period.

* Average Cost — This method is quite straight forward, it takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of cost of goods sold and ending inventory. In our bakery example, the average cost for inventory would be Rs 1.125 per unit, calculated as (200 x Rs 1 + 200 x Rs 1.25)/400.

The most important point in the examples above is that cost of goods sold appears on the income statement, and ending inventory appears on the balance sheet under current assets.

WHY IS THIS IMPORTANT?

If inflation is non-existent, then all three of the inventory valuation methods will produce the exact same results. When prices are stable our bakery would be able to produce all of its loafs of bread at Rs 1, and FIFO, LIFO, and average cost would give us a cost of Rs 1 per loaf.Unfortunately, the world is more complicated. Over the long term, prices tend to rise, which means the accounting method can dramatically affect valuation ratios.

If prices are rising, each of the accounting methods produces the following results:

* FIFO gives us a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value cost of goods sold. Increasing net income sounds all good, but remember that it also has the potential to increase the amount of taxes that a company must pay.

* LIFO isn't a good indicator of ending inventory value because the left over inventory might be extremely old. This results in a valuation that is much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher.

* Average cost produces results are somewhere in the middle between FIFO and LIFO.

(Note: if prices are decreasing then the complete opposite is true.)

One thing to keep in mind is that companies are prevented from getting the best of both worlds. If a company uses LIFO valuation when they file their taxes, which results in lower taxes when prices are increasing, they then must also use LIFO when they report financial results to shareholders. This lowers net income and ultimately lowers earnings per share.

Illustration Trough a Hypothetical Example:

Let's use an example for ABC Co. to see how the different inventory valuation methods can affect the financial analysis of a company.

Monthly Inventory Purchases

 Month Units Purchased Cost Total Value April 2000 Rs. 10 20000 May 2000 Rs. 15 30000 June 2000 Rs. 20 40000 Total 6000 . 90000

Beginning Inventory = 2000 units purchased at Rs. 8 each (for a total of 8000 units)

Income Statement (simplified): April - June

LIFO FIFO Average

 Sales = 6000 units @ \$20 each 120,000 120,000 120,000 Beginning Inventory 16,000 16,000 16,000 Purchases 90,000 90,000 90,000 Ending Inventory 2000 units (appears on B/S) *See calculation below 16,000 40,000 26,500 COGS Rs. 90,000 Rs. 66,000 Rs. 79,500 Gross Profit Rs. 30,000 Rs. 54,000 Rs. 40,500 Expenses 20,000 20,000 20,000 Net Income Rs. 10,000 Rs. 34,000 Rs. 20,500

What we are doing here is figuring out the ending inventory, the results of which depend on the accounting method, in order to find out what COGS is. All we've done is rearranged the above equation into the following:

Beginning Inventory + Net Purchases - Ending Inventory = Cost of Goods Sold

All calculations assume that there are 2000 units left for ending inventory (8000 units - 6000 units sold = 2000 units left)

* LIFO Ending Inventory Cost = 2000 units X Rs. 8 each = Rs. 16,000

FIFO Ending Inventory Cost = 2000 units X Rs. 20 each = Rs. 40,000

Average Cost Ending Inventory =[(2000 x 8) + (2000 x 10) + (2000 x 15) + (2000 x 20)]/8000 units = Rs. 13.25 per unit

2000 units X 13.25 each = Rs. 26,500

Using the information above, we can calculate various performance and leverage ratios. Let's assume the following:

 Assets (not including inventory) Rs. 250,000 Current assets (not including inventory) Rs. 200,000 Current liabilities Rs. 80,000 Total liabilities Rs. 100,000

Each inventory valuation method causes the various ratios to produce significantly different results (excluding the effects of income taxes):

 Ratio LIFO FIFO Average Cost Gross Profit Margin 25% 45% 33.75% Current Ratio 2.7 3.0 2.83 Inventory Turnover 5.63 2.36 2.30 Debt-to-Asset 0.46 0.42 0.4

As you can see from the ratio results, inventory analysis can have a big effect on the bottom line. Unfortunately, a company probably won't publish their entire inventory situation in their financial statements, but they are required to state in the "notes to financial statements" what inventory system they use. By learning how these differences work, you will be better able to compare companies within the same industry.

As a final note, many companies will also state that they use the "lower of cost of market." This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of FIFO, LIFO, or average cost.This might seem like an exhaustive look at an otherwise overlooked part of a company's financial statements, but it's something you need to be at least aware of. Next time you're valuing a company, check out their inventory; it might reveal more than you thought and would might change your investing decision.