115 CFA
File: Financial Analysis - Reading 25 - 6. Financial Analysis of Inventories

6. Financial Analysis of Inventories

i. describe the financial statement presentation of and disclosures relating to inventories;

j. explain issues that analysts should consider when examining a company's inventory disclosures and other sources of information;

k. calculate and compare ratios of companies, including companies that use different inventory methods;

l. analyze and compare the financial statements of companies, including companies that use different inventory methods.

What is inventory turnover ratio? What is the formula?
- Inventory turnover measures how fast a company moves its inventory through the system.
- $$inventory\ turnover = \frac{COGS}{average\ inventory}$$

Why have tax benefits become a major reason that LIFO has become popular?
As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs. "Whatever is good for tax is good for financial reporting."

Why is LIFO a good earnings hedge?
With LIFO, a company's future reported earnings will not be affected substantially by future price declines. Since the most recent inventory is sold first, there isn't much ending inventory sitting around at high prices, vulnerable to a price decline.

How does FIFO and LIFO affect COGS and Income reporting?
Since LIFO allocates the most recent purchase prices to COGS, the use of LIFO results in higher COGS and lower reported income. In contrast, FIFO allocates the earliest purchase prices to COGS, resulting in lower COGS and higher income.

How does FIFO and LIFO affect profitability? Which should be used for analysis?
- Profit margin = net income / sales
- Since FIFO results in lower COGS and, therefore, higher net income, profit margins will be higher under FIFO. The net income provided by LIFO is more useful and the lower profit margins reported under LIFO should be used in analysis.

What is the current cost inventory turnover formula? How is it different than the regular inventory turnover formula?
- $$inventory\ turnover\ (Current\ Cost) = \frac{COGS\ (LIFO)}{average\ inventory\ (FIFO)}$$
- It is only different than the regular formula in that you use LIFO method for COGS (because they're more current/accurate) and the FIFO method for inventory (because it is more accurate for inventory)

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