Question

How does net income, profitability ratios, asset utilization ratios, and tax benefits differ under LIFO versus FIFO?

Answer 1

Impact on Net Income & Profitability ratios:

The inventory method used by company affects the costs of goods sold, which has an impact on its profitability ratios. As profit is Sales less cost of goods sold (COGS)

The formula for COGS is beginning inventory plus purchases less ending inventory. A company using FIFO to value its inventory reports lower COGS, which increases its gross profit margin (sales less COGS). Higher net income means higher profit margin.

A company using LIFO reports higher COGS, translating into lower gross profit, net profit and profit margins.

Asset Utilization ratios:

The inventory method a company uses affects its assets utilization ratios as well. FIFO companies report higher inventory in their current assets. This results in a higher current ratio (current assets divided by current liabilities). In contrast, a company using LIFO reports lower ending inventory, producing a lower current ratio. Net return on assets (net income divided by average assets) look better under LIFO than FIFO. Asset turnover (sales divided by total assets) , the turnover ratio would be higher in FIFO due to more value of assets and vice-versa. And inventory turnover (COGS divided by average inventories) also effected by methods used in calculating closing inventory in same way.

Tax implications:

Tax law allows a company to value its ending inventory using LIFO as it results in a lower tax liability even though it reports FIFO for financial reporting. However, a publicly-traded company must disclose a LIFO reserve. When added together with the LIFO valuation, the LIFO reserve produces the valuation of inventory under FIFO for analysis purposes. Investors should also take note that in times of rising prices, LIFO valuation produces a more accurate assessment of a company's inventory. In such a case, inventories under FIFO may be obsolete and dated, which is not a true reflection of inventory costs.