CFA I (1) Inflation impact on LIFO

In an environment of inflation impact, which refers to an increasing inventory unit costs and constant or decreasing inventory quantities, LIFO (in comparison with weighted average cost or FIFO) will allocate a higher amount of the total cost of goods in the income statement and a lower amount to ending inventory on the balance sheet.

For Income Statement, inflation will result in a higher cost of sales, thus lower gross profit, lower operating income, lower income before taxes, lower net income, and thus LOWER income TAX EXPENSES, thus HIGHER NET OPERATING CASH FLOW.

For Balance Sheet,  inflation will cause lower ending inventory, thus lower reported current asset, lower working capital, therefore lower total asset.

The potential income tax savings are a benefit of using the LIFO method when inventory costs are increasing. The higher cash flows due to lower income taxes may make the company more valuable because the value of company is based on the present value of its future cash flows.

Under theLIFO COMFORMITY RULE,the US. tax code requires that companies using the LIFO method for tax purposes must also use the LIFO method for financial reporting. Under the LIFO method, the ending inventory is assumed to consist of those units that have been  held the longest.This generally results in ending inventories with carrying amounts lower than current replacement costs because inventory costs typically increase over time. Cost of sales will more closely reflect the current replacement costs.

Furthermore, the LIFO valuation model also press influence on the financial ratios through its adjustments on ending Inventory and cost of sales.

Three ratios are often used to evaluate the efficiency and effectiveness of inventory management are inventory turnover, days of inventory on hand, and gross profit margin. These ratios are directly impacted by a company's choice of inventory valuation method. Many other ratios are also affected by the choice of inventory valuation method, although less directly. These include the current ratio, because the inventory is a component of current assets; the return-on-assts ratio, because cost of sales is a key component in deriving net income and inventory is a component of total assets; and even the debt-to-equity ratio, because the cumulative measured net income from the inception of a business is an aggregate component of retained earnings.

Holding the inflation condition, Inventory Turnover Ratio (Cost of goods sold / Average Ending Inventory) is higher under LIFO, and the Days of inventory on hand ( Number of days in period / Inventory turnover ratio) is shorter, indicating that a company using the LIFO method might appear to manage its inventory more effectively. This is primarily the result of the lower inventory carrying amounts under LIFO.

LIFO method will also make the company appear less profitable through lower gross profit margin, lower net profit margin, lower return on assets. Meanwhile, the company will appear less liquid with a lower current ratio under LIFO. Oppositely, higher total liabilities-to-equity ratio means the company appears to be more highly leveraged under LIFO.

In summary, the company appears to be less profitable, less liquid, and more highly leveraged under LIFO. Yet, because a company's value is based on the present value of future cash flows, LIFO will increase the company's value because the cash flows are higher in earlier years due to lower taxes. LIFO is primarily used for the tax benefits it provides.