Question

Assume that there are two companies identical in every way except that Company A uses FIFO and Company B uses the average cost method to value their inventory.

If both companies visited a bank for the purpose of obtaining a loan due to rising inventory costs and the bank made its decision based on the highest net income, which company would be better positioned to obtain the loan?

What if the bank made its decision based on the highest cash flows associated with the inventory costing method the company uses? Which company would be better positioned to obtain the loan? Elaborate on your responses for the above questions.

Answer 1

FIFO, Weighted average cost method are the method used to value inventory.

The FIFO method assumes that the first goods purchased are to be sold first. As a result the ending inventory posted in the balance sheet is close to the current price since prices tend to increase overtime. So under FIFO method the cost recorded is low and income is higher.

The average cost method uses formula for valuation of inventory. Total cost of goods available for sale divided by total units available for sale over a period. This method is used when it is not possible to assign a specific cost to an individual unit.

If the company needs to maintain relatively strong balance sheet, to qualify for loans, to attract investors FIFO is the better choice.

As per the information provided, the Company A follows FIFO and Company B follows average cost method and the companies approched the backs for obtaining loans due to rising inventory cost.

The net income of the company A would be higher as it uses FIFO method for the valuation of inventory. Under this method the earliest the goods purchased are the first ones to remove from inventory. So it shows higher income in the statement. The cost of inventory purchased first is lower than the recent ones in the increasing price environment. The net income of the company B would be lower as it follows average cost method. So if the Bank made its decision based on net income, Company A would be in better position to obtain loan.

The company A is using FIFO method for the valuation of inventory, so the company reports high taxable net income. It increases the cash out flow. Tax expenses are real cash expenses and lower company's cash flow.

The company B is following average costing method, the recorded amount of inventory is between the oldest and newest unts purchased and similarly the cost of goods sold reflect the cost between the oldest and newest units sold in a period. The net income of the company B may be lower than that of company A. So the tax liability also will be lower resulting in lower cash outflow.

If the bank made the decison of loan disburesment on the basis of cash flow, then Company B would be in better positin to obtain the loan.