Question

Why would roa be lower for a company going through inflation using FIFO if net income and assets are rising rather then if they used LIFO method. Shouldn’t a company with a higher net income and average total asset give a higher ROA than the company using LIFO? And how would EPS and debt to equity be affected if fifo and lifo is used. Please be as clear as you are able to. Thanks

Answer 1

EFFECT ON FINANCIAL RATIO (ROA) WHEN USING LIFO INSTED FIFO:-

During periods of significantly increasing costs i.e. during the period of inflation, LIFO when compared to FIFO will cause the lower inventory costs on balance sheet and a higher cost of goods sold on the income statement.

This will mean that the profitibility ratios ( in our case ROA) will be smaller under LIFO than FIFO.

for more undrstanding if we consider "Inventory turnover ratio" (which is a profitability ratio as like ROA):-

The inventory turnover ratio will be higher when LIFO is uded during periods of inflation (increasing costs). The reason is that, the cost of goods sold will be higher and the inventory cost will be lower undr LIFO than under FIFO.

Lets go further to understand in simple terms:-

EXAMPLE:-

consider a year where sales are 100 and net income is 12.

under FIFO, begining equity is 150 and egining assets is 300. ( assum no dividents are distributed)

so ending equity and assets are = 162 (150+12) and 312 (300+12) respectively.

Average equity is (150+162)/2 = 156

Average assets are (300+312)/2 = 306

therefore;

ROE = 12/156 = 7.69%

& ROA = 12/306 = 3.92%

in case of LIFO method:-

net income is just 10. so

average equity is 155 and average assets are 305

therefore;

ROE = 10/155 = 6.45%

& ROA = 10/305 = 3.28%

conclusion,

ROE & ROA are higher under FIFO. The mathematical explanation is that net income under FIFO is 20% higher than net income under LIFO (12 vs 10), however average equity and average assets are only 0.65% and 0.33% higher under FIFO compared to LIFO

HOPE YOUR DOUBT IS CLEARED .