Question

When making investment decisions, why is it important to know what type of inventory costing system the company uses? Give two examples of ratios and accounts that may be affected by a company's inventory costing method choice.

Answer 1

It is important to determine the type of inventory system the company, using before investment into the company because there are various inventory management system which will be reflecting on the books of accounts like first In and first out along with last in and first out and average inventory so these valuation methods will be leading to impact the profits of the company and it will also mean that they are going to provide the nature of the company in order to report the profits and increase their Liquidity.

Examples of ratios and accounts which will be affected by inventory costing methods are -

A. Current ratio- current ratio will be highly affected because inventory are forming a major part of current asset and this Inventory will be compared in respect to the current liabilities in order to arrive at the current ratio so if the company is using last in and first out method, it will be having a lower overall cost of goods sold in its hands due to selling of the units which required at last and recording at the units which were acquired in the beginning at a lower book value.

B. Total assets to turnover ratio- total assets turnover ratio will be affecting the ability of the company in order to utilise their asset to generate a higher amount of sales so when there will be a higher amount of assets, which are used by company then, it is more likely that the company will be able to generate more sales by using those assets.

inventory will be forming a major part of total Assets and valuation of inventory can be leading to inflation and deflation of the total assets so it will be reflecting into the total asset turnover ratio.