Test Two

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Statement of Cash Flows (SCF)

-Uses accrual accounting and doesn't tell about the sources and uses of cash.
-positive net income is insignificant
-provides important analytical information from the income statement that converts accrual accounting to a cash basis presentation
-Connects period to period changes in the balance sheet account values with changes in cash flows.
-Reports all cash inflows and outflows, or changes in the organizations balance sheet over a specific time period.

Cash flows from operating activities

Consists of the inflows and outflows of cash resulting from transactions that affect a firm's net income

-Under US GAAP uses of CFO include the payment of dividends, repurchase equity, replace or expand capacity, and/or acquire growth.

Operating Activities

-inflows include revenue from sales of goods, services, dividends received (not paid) from equity securities and interest income on interest bearing assets.

-Outflows consist of payments for inventory purchases, payments of operating expenses, payments to suppliers, INTEREST PAYMENTS to lenders of the company and tax payments to the IRS.

preparing a statement of cash flows

-items come from the income statement items AND changes in the balance sheet accounts.
-A firms cash receipts and payments are classified on the cash flow statement as, O, I, and F.
-Prepared by calculating the changes in all of the balance sheet accounts, including cash, then listing the changes in all of the accounts, excluding cash as inflows and outflows.
-the inflows less the outflows net to the change in cash during the same period.

cash flow from investing activities

"reports the cashed used and received (proceeds from sales) to acquire assets (PP&E) as well as other businesses (acquisitions).

-CFI is necessary to maintain current operating capacity and future growth, includes cash received from sale or disposal of assets or business segments.

5 examples of CFI

-purchases (outflows) or sales (inflows) of property, plant, and equipment.
-investments in joint ventures and affiliates (outflows)
-payments for businesses acquired (outflows)
-proceeds from sales of assets (inflows)
-purchases (outflow) or sales (inflows) of marketable securities.

Purchases and sales of equipment

-investing cash flows are calculated by examining the change in the "gross" asset accounts that result in investing activities such as PP&E, intangible assets, and investment securities.
-Related accumulated depreciation or amortization are ignored since they do no represent cash expenses.
-"gross" means an amount that is presented on the balance sheet before any accumulated depreciation or amortization.

When calculating the cash paid for a new asset...

-it is necessary to determine whether old assets were sold.
If so:
-beginning gross assets + cash paid for new assets - gross cost of assets sold = ending gross assets.

when calculating the cash from an asset that has been sold....

-it is necessary to consider any gain/loss from the sale using formula.

gain/loss on sale = sales proceeds - net book value of the asset.

cash flow from financing activities

Consists of the inflows and outflows of cash resulting from transactions affecting a firm's capital structure.

-financing cash flows are determined by measuring the cash flows occurring between the firm and its suppliers of capital. Cash flows between the firm and creditors result from new borrowing and debt repayments.

-interest paid (included in CFO)
-cash flows between the firm and the shareholders occur when equity is issued, shares are repurchased, and dividends are paid.

Examples of CFF

CFF includes proceeds from:
-stock issuance (inflow of cash)
-repurchase of a firm's own shares (treasury stock) (outflow to pay for the stock)
-dividend payments (outflow of cash to pay stockholders)
-Issuance of debt (inflow of cash from the bond buyers)
-repayment of debt principal (outflow of cash to pay the bondholders)

Dividends received vs. dividends paid

dividends received (operating)
dividends paid (financing)

CFF is the SUM of WHAT two measures?

1. net cash flows from creditors = new debt borrowings - debt principal repaid
2. Net cash flows from shareholders = new equity issued - share repurchases - cash dividends paid.

WHERE...
-cash dividends are measured using dividends declared plus/minus changes in dividends payable.

US GAAP vs. IAS GAAP (IFRS)

(US GAAP, IFRS)

Interest received (CFO, CFO or CFI)
Interest paid (CFO, CFO or CFF)
Dividends received (CFO, CFO or CFI)
Dividends Paid (CFF, CFO or CFF)

-IASB allows more flexibility in the reporting of items.

Non-cash investing and financing activities

-all items below will affect the balance sheet but do not affect the cash flow statements as no cash is collected or paid out by the firm.

1. retirement of debt via conversion into equity
2. conversion of preferred stock into common stock.
3. assets acquired under capital leases
4. obtaining assets (real estate) by issuing notes payable (seller financing)
5. exchange of one non-cash asset for another
6. purchase of non-cash assets by issuing equity or other securities.

3 anomalies within the SCF

1. The acquisition of debt and equity investments (other than trading securities) and loans made to others are reported as investing activities, however, the income from these investments (interest received and dividends received) is reported as an operating activity.
2. Principal amounts borrowed from others are reported as financing activities, however, interest paid or cost of financing is reported as an operating activity.
3. Dividends paid to shareholders are financing activities and dividends received are operating activities.

analysts implications of non-cash transactions

-noncash transactions must be disclosed in either a separate footnote or a supplemental schedule to the cash flow statement
-analysts should be aware of the firm's non-cash transactions and incorporate them into analysis of past and current performance, and include their effects in future projections.

Two methods of presentation (direct and indirect)

-both methods are permitted under US GAAP and IAS, however, use of the direct method is encourage by both setters although most firms select the indirect method.

-the difference in the two methods relates to the presentation of cash flow from operations
-the presentation of investing and financing activities are exactly the same under both methods.

CFO (direct method)

-cash inflows (receipts)
LESS
-cash outflows (disbursements)
EQUALS
CFO

CFO (indirect method)

Net Income
+ depreciation and amortization
- gains on disposal of L-T assets
+losses on disposal of L-T assets
+other non-cash expenses (Change in deferred tax)
-non-cash revenues (equity investment)
+/- changes in non-cash operating working capital accounts

EQUALS
CFO

Direct Method

-Begins at the TOP of the income statement with gross cash receipts and identifies cash inflows and outflows to result in net change in cash.
-converts an accrual-based income statement into a cash-basis income statement.

Indirect Method

-begins at the BOTTOM of the income statement with net income and make necessary adjustments to derive the change in cash.
-net income is converted to operating cash flow by making adjustments for transactions that affected net income but did not affect cash.

-eliminate non-cash expenses (deprec. and amotization)
-operating items (gains and losses on asset sales)
-changes in the balance sheet accounts that are affected by accrual accounting events (working capital capital items)

Advantages of each method (direct and indirect)

DIRECT:
-presents the firm's operating cash receipts and payments while the indirect method only presents the net result of these receipts and payments.
-provides more information that the indirect method.

INDIRECT METHOD:
-focuses on the differences in net income and operating cash flow.
-provides a useful link to the income statement when forecasting future operating cash flow.

Direct versus Indirect Method

-indirect format reports the net cash flow from operations, it doe not facilitate the comparison and analysis of operating acsh inflows and outflows by function with revenue and expense activities that generated them, as is possible with the direct method.

-direct method- preferred method, but less often used by corporations.

-transactional analysis, is a techique that can be used to help create a cash flow statement for firms that do no prepare cash flow statements in accordance with SFAS 95, in addition, it can be used to help convert indirect cash flow from operations to the direct method.

Change in Accounts Receivables (CFO)

I: net sales
CF: cash from customers

Change in Advances from customers (CFO)

I: net sales
CF: cash from customers

Change in inventory and Accounts payable (CFO)

I: cost of goods sold
CF: Cash paid for inputs

Change in prepaid expenses (CFO)

I: SG&A expense
CF: cash operating expenses

Change in rent payable (CFO)

I: rent expense
CF: cash operating expenses

Change in accrued expenses (CFO)

I: SG&A expense
CF: Cash operating expense

Change in interest payable (CFO)

I: interest expense
CF: interest paid

Change in income tax payable and deferred taxes (CFO)

I: income tax expense
CF: income tax paid

Plant Property and Equipment (CFI)

I: depreciation expense
CF: capital expenditures

Intangible Assets (CFI)

I: amortization expense
CF: capital expenditures

Short and Long term investment gains (losses) on certain investments (CFI)

I:Realized gains or losses in investments
CF: Cash paid for and received from investments

Assets and liabilities resulting from acquisitions and divestitures (CFI)

I: nothing
CF: Cash paid for acquisitions or received from divestitures

dividends payable (CFF)

CF: Dividends paid

notes payable (CFF)

CF: Inc/(dec) in debt

Current Portion of Long Term Debt (CFF)

CF: Inc/(dec) in debt

Long Term Debt (CFF)

CF: Inc/(dec) in debt

Bonds Payable (CFF)

CF: Inc/(dec) in debt

Common Stock and APIC (CFF)

CF: Inc/(dec) in equity

Retained Earnings (CFF)

CF: Dividends Paid

Rules: Cash Inflows and Outflows

-an increase in an asset such as A/R or inventory, uses cash - outflow (inverse)
-a decrease in an asset is a source of cash and a cash inflow (inverse)


-an INCREASE in a liability (payables), generates cash - inflow (direct)
-a DECREASE in a liability is a use of cash and a cash outflow (direct)

Remember the following points...

-CFO is calculated differently between the direct and indirect methods, but the result is the same.
-The calculation of CFI and CFF is the same under both methods.


-Sources of cash are positive numbers and uses of cash are negative numbers

Indirect method -CFO

1. start with net income
2. Subtract gains or add losses that result from financing or investing cash flows (such as gains from sale of land)
3. Add back all noncash charges to income (such as depreciation and amortization) and subtract all noncash revenue components
4. Add or subtract changes to operating accounts as follows:


Increases in an asset - deduct
Increase in a liability - add
Decrease in an asset - add
Decrease in a liability - deduct

Direct Method

-The direct method calculates operating cash flow by taking each item from the top of the income statement, beginning with sales revenue, and converting it to its cash equivalent by adding or subtracting the changes in the corresponding balance sheet accounts.
-Footnotes are often helpful in learning how inflows and outflows have affected the balance sheet accounts.

Cash collected from sales

is the principle component of CFO. Cash collections are calculated by adjusting sales for the changes in accounts receivable and unearned (deferred) revenue.

Cash used in the production of goods and services

) is calculated by adjusting cost of goods sold (COGS) for the changes in inventory and accounts payable.

Cash operating expenses

calculated by adjusting selling, general, and administrative (SG&A) expenses for the changes in the related accrued liabilities and prepaid expenses.

Cash paid for interest

calculated by adjusting interest expense for the changes in interest payable. The amortization of a bond discount (added back to) or premium (subtracted from) net income to arrive at cash flow from operations.

Cash paid for taxes

is calculated by adjusting income tax expense (I/S item) for changes in taxes payable (B/S) and changes in deferred taxes and liabilities (B/S).

direct method trick!

Ignore depreciation expense —it's a non-cash charge.

Direct Method CFO STEPS

1. Start at the top of the income statement - e.g., Sales
2. Move to the balance sheet and identify any asset and liability that relate to that income statement item - e.g., Accounts Receivable
3-4. look at balance sheet and apply rule
5. Adjust the Income Statement amount by the change in the Balance sheet
6. Tick off the items dealt with in both the Income Statement and Balance sheet
7. Move to the next item on the Income Statement and repeat
8. Ignore depreciation/amortization and gains/losses on the disposal of assets as these are all non cash items
9. Keep moving down the Income Statement until all items included in Net Income have been addressed applying steps 1-8
10. Total up the amounts and you have CFO

Cash paid to suppliers

= - COGS + decrease in inventory + increase in accounts payable
= -$40,000 + $2,000 + $4,000 = -$34,000

beginning inventory + purchases - COGS = ending inventory
= $7,000 + $38,000 (not provided) - $40,000 = $5,000

beginning accounts payable + purchases - cash paid to suppliers = ending accounts payable
= $5,000 + $38,000 (not provided) - $34,000 = $9,000

Cash wages

= - wages - decrease in wages payable
= -$5,000 - $3,500 = -$8,500

beginning wages payable + wages expense - wages paid = ending wages payable
= $8,000 + $5,000 - $8,500 = $4,500

Cash interest

= - interest expense + increase in interest payable
= -$500 + $500 = 0

beginning interest payable + interest expense - interest paid = ending interest payable
= $3,000 + $500 - $0 = $3,500

Cash taxes

= - tax expense + increase in taxes payable + increase in deferred taxes

= -$20,000 + $1,000 + $5,000 = -$14,000

beginning taxes payable and deferred taxes + tax expense - taxes paid = ending taxes payable and deferred taxes

= $19,000 + $20,000 - $14,000 = $25,000

Analysis of Cash Flow Information

*The SCF helps provide objective information about:

1. A firm's ability to generate cash flows from operations:
-Turn assets into cash inflows
-Repay liabilities
-Generate positive returns to shareholders

2. Trends in cash flow components and the consequences of investing and financing decisions
3. Management's decisions regarding important areas of leverage, dividend policy and investment for growth

major sources and uses of cash

-Cash flow analysis begins with an evaluation of the firm's sources and uses of cash from all three categories: operating, investing, and financing activities.
-Sources and uses of cash change as the firm moves through the life cycle. For example, when a firm is in the early stages of growth, it may experience negative operating cash flow as it uses cash to build-up inventory and receivables.
-This negative cash flow is usually financed externally by issuing debt or equity. These sources of financing are not sustainable. Eventually, the firm must begin generating positive operating cash flow or the sources of external capital will dry up.

-Over the long-run, successful firms must be able to generate operating cash flows that exceed capital expenditures.

Generating Operating Cash Flow

-The analyst should identify the major determinates of operating cash flow.

-Positive operating cash flow can be generated by the firm's earning related activities. However, positive operating cash flow can also be generated by decreasing working capital such as liquidating inventory and receivables, or increasing payables.

-Decreasing working capital is not sustainable in the long term, as inventories and receivables cannot fall below zero and creditors will not extend credit indefinitely unless payments are made.

Earnings Quality

-Operating cash flow also provides a "check" on the quality of a firm's earnings.
-A stable relationship of operating cash flow and net income is an indication of quality earnings.
-Earnings that exceed operating cash flow may be an indication of aggressive accounting choices such as recognizing revenues too soon or delaying the recognition of expenses.
-The variability of net income compared to operating cash flow should also be evaluated since accruals and deferrals will be the primary cause for these variations

Investing Cash Flow Analysis

-The sources and uses of cash from investing activities should be examined.

-Increasing capital expenditures, a use of cash, is usually an indication of growth.

-a firm may reduce capital expenditures or even sell capital assets in order to save or generate cash. This may result in higher cash outflows in the future as older assets are replaced or growth resumes.

Financing Cash Flows

-The financing activities section of the cash flow statement reveals information about whether the firm is generating cash flow by issuing debt or equity.

-provides information about whether the firm is using cash to repay debt, reacquire stock or pay dividends.

For example, an analyst would certainly want to know if a firm issued debt and used the proceeds to reacquire stock or pay dividends to shareholders.

Operating Assets and Liabilities: Balance Sheet versus Cash Flow Statement

Discrepancies between changes in balance sheet accounts and cash flow statement adjustments for changes in balance sheet accounts may arise from:

1. Acquisitions and divestitures: inventory increases from the acquisition of a business are not operating cash flows

2. Foreign subsidiaries: assets and liabilities of foreign subsidiaries are adjusted for changes in their reporting currency values when exchange rates change

Free Cash Flows and Valuation

Free cash flow measures the cash available to the firm for discretionary uses after making all required cash outlays.

free cash flow is measured by:

Free Cash Flow = Operating cash flow - Net capital expenditures
THEN:

= Expenditure on capital items - after tax sales proceeds from disposals

Two measures of FCF can be used by the analyst:

FCF = CFO - Net Capital Expenditures
FCF = CFO - CFI

Relationship of Income to Cash Flow - Acct Choices

-Trends in capital expenditures
-Acquisitions and divestitures
-Variability of income as a predictor of future cash flows
-Effect of timing and recognition differences

Examples: Intel, Kmart and Westvaco

Analysis of Cash Flow - Liquidity

-If a firm's growth is too fast, liquidity issues can arise
-Growth requires capital expenditures which can result in negative FCF
-Inventories can create a cash drag if payment for COGS is required before prior goods and services are sold and cash collected

Analysis of Cash Flow Trends

Procedures for analytical purposes:
-Review individual cash flow items for significance
-Examine the trend of individual cash flow components over time
-Consider the interrelationship between cash flow components over time

CFO- Grow in CFO over time (best method for analysis?)
CFI - Significant increases in capital expenditures for PP&E
CFF - Repurchases of stock and dividend payments
Increase in investment in securities while also an increase in short term borrowing...borrowing and investing short term?

Interest and Dividends Received , Analytical Perspective

-Under SFAS 95 interest income and dividends received from investments from other firms are classified as operating cash flows (CFO).
-return ON capital is separated from the return OF capital.
-Reclassification of after-tax dividend and interest from CFO to CFI has the effect of removing investing activities from operations. As a result, cash flow from operations reflects only operating activities from the firm's core business.

Interest Payments, Analytical Perspective

-interest payments are classified as operating cash outflows. Interest is deducted in arriving at net income
-Interest payments are the result of capital structure and leverage decisions which reflect financing risk
-interest payments (net of tax) should be reclassified as financing cash flows.

Non-comparability results:
-Levered firms deduct interest paid from CFO to pay creditors
-Dividends paid to shareholders are reported as financing cash flows

Illogical Classifications under U.S. GAAP

1. Interest expense is shown as an operating activity (operational expense) and and deducted from CFO, while...principal payments are shown as financing activities - CFF
2. Dividends received and interest received are shown as additions to operating activities (CFO) NOT investing activities (CFI)
3. Under IAS interest expense and dividends/interest received can be shown under either CFO or CFI

objective of inventory accounting

-To determine the value of inventory that best achieves the matching of costs to revenues for the same accounting period
-Inventory is an asset on the balance sheet and is considered part of the firm's working capital.
The asset can be comprised of 3 separate accounts: raw materials, work in process and finished goods

-Once the asset is sold, capitalized inventory is expensed and becomes part of cost of goods sold on the income statement

Basic Relationships

Inventory is affected by two events:
1. Purchase of goods (P)
2. Sale of the goods (COGS)

Goods available for sale (GAS) = Beginning Inventory + Purchases

-Beg Inv + Purchases = Cost of Goods Sold + End Inv

Inventory Capitalized Costs

-included in the cost of inventory on the balance sheet:

-Costs of purchase
-Costs of conversion - labor costs
-Freight and delivery costs
-Direct costs of acquisition
-Allocated overhead costs (indirect materials, indirect labor and other costs such as depreciation, taxes and insurance)

Inventory Period Costs

expensed on the income statement, they are excluded from the inventory costs on the B/S. They are indirectly related to the acquisition or production of the goods.
-Abnormal costs incurred due to waste of materials
-Abnormal labor waste
-Overhead conversion costs from production
-Storage costs
-Administrative overhead and selling expenses

Inventory Valuation

IAS 2 states that inventory should be carried on the B/S at the lower of cost or "net realizable value"

Lower of costs

All costs of bringing the inventory to its current location and condition (based on normal production levels) and excludes: Abnormal amounts, storage costs, admin overheads and selling costs

Net realizable value (NRV)

is the estimated selling price less the estimated costs to make the product sale

NRV = Estimated selling price - estimated cost of completion - selling costs

Lower-of-Cost-or Market Principal

-LCM is not an inventory costing method
-LCM is a GAAP valuation test to ensure inventory is not overvalued on the balance sheet compared to its future benefits derived from its subsequent sale

-The basis for the LCM rule is that historical cost method should be discontinued when the future benefit of the inventory is no longer as great as its original cost

Inventory Write Downs

-If the value of inventory declines below the cost of the inventory (balance sheet book value) a write-down (loss) is recognized on the income statement as an unusual or infrequent item in the period they are incurred.
-Under IAS 2, inventory reversals can be recognized (limited to the amount of the original write-down) for later increases in inventory value.
-Under US GAAP, the LCM is used to value inventories. Market value is defined by the following constraints:
-Upper valuation limit = NRV
-Lower valuation limit = NRV - normal profit margin
-Reversals of write-downs is prohibited!

Inventory Accounting Methods

1. IAS 2 the cost of inventories is assigned by three different methods: First-In First-Out (FIFO), weighted average cost and specific identification.

2. U.S. GAAP recognizes four different methods of inventory cost flow: Last-in, First-out (LIFO), FIFO weighted average cost and specific identification.

FIFO

-The items first purchased are the first items to be sold
-COGS consists of... first purchased
-ending inventory consists of... most recent purchases - economically more appropriate

LIFO

-The items last purchased are the first to be sold
-COGS consists of... last purchased - more economically appropriate
-Ending inventory consists of... earliest purchases

Weighted Average

-Items sold are a mix of purchases
-COGS consists of... average cost of all items
-Ending inventory consists of... average cost of all items

Specific identification

-ending inventory consists of actual costs of specific items and matches the physical flow of items sold

Balance Sheet - Inventory (use FIFO)

-From a balance sheet perspective, inventories based on FIFO are preferable to those presented under LIFO, as carrying values most closely reflect current cost in times of rising prices.

-FIFO inventory provides a better measure of inventory on the balance sheet that is closer to its current (economic) value.

Income Statement - Cost of Goods Sold (use LIFO)

-Since U.S. GAAP uses a historical cost framework, replacement cost accounting is not permitted.
-LIFO allocates the most recent purchase prices (highest in times of rising prices) to the cost of goods sold doing well to match revenues from items sold with recent costs.
-During periods of changing prices and stable or growing inventories. LIFO is the most informative and conservative accounting method for income statement/COGS purposes since it provides a better measure of current income and future profitability

Use FIFO COGS on I/S During Rising Prices

Under rising prices, FIFO will result in the lowest COGS (because the last goods purchased are the least expensive) and the highest gross margins, operating profit and pre-tax income.

-The lower the FIFO COGS, the higher the ending inventory balance
-income taxes will be higher under FIFO
-net cash flow will be lower under FUFO

Use LIFO COGS on I/S During Rising Prices

Under rising prices, LIFO will result in the highest COGS (because the last goods purchased are the most expensive) and the lowest gross margin, operating profit and lowest pre-tax income.
-The higher the LIFO COGS, the lower the ending inventory balance

-income taxes will be lower under LIFO
-net cash flow will be higher under LIFO

Management choices

If costs do not change, then the different inventory methods do not affect the financial statements

LIFO liquidation

-By decreasing inventory to levels below "normal" levels, thus dipping into older, less expensive inventory, a company's management can manipulate profits (lower COGS resulting in higher profits) under LIFO accounting.

-If there is a LIFO liquidation, LIFO COGS and therefore net income become distorted on a period over period basis

LIFO vs. FIFO Effects on Income, Cash Flow and Working Capital

-IRS regulations require that the same method of inventory accounting used for tax purposes also be used for financial reporting purposes.

-When LIFO is used for income tax computation, lower pre-tax income translates into lower income taxes and thus higher operating cash flows (CFO).

-LIFO also results in lower inventory balances which reduces working capital (current assets - current liabilities) on the balance sheet

So Why Adopt FIFO instead of LIFO?

-there will be an increase in their reported working capital.

Why do We Need Adjustments?

-When two firms use different accounting methods for inventory, one of the firm's inventories must be adjusted to make a valid "apples-to-apples" comparison.

The primary types of conversions include:
LIFO to FIFO balance sheet conversion
FIFO to LIFO income statement conversion
Weighted average to LIFO conversion

LIFO Reserve Defined

-LIFO inventory balances generally contain older costs with little or no relationship to current, replacement costs.
-Due to this deficiency, firms are required to disclose in their footnotes or on the balance sheet the "LIFO reserve"


LIFO RESERVE = Inv FIFO - Inv LIFO

Economics of Inventory Balances using FIFO

-FIFO inventory on the B/S accurately reflects the economic value of the ending inventory because under FIFO, ending inventory is valued at more recent purchase prices.

-LIFO inventory, under times of rising prices, will be lower than that reported under FIFO. Reported inventory balances will not be related to their current economic value, because ending inventory under LIFO is valued at prices that occurred in prior periods.

-AVCO inventory during periods of rising prices will be between inventory values using FIFO and LIFO. AVCO inventory will be closer to true economic valuation than LIFO but will still lag true economic value.

Economics of COGS and its Effect on Earnings

-LIFO most accurately reflects the economic costs to the company because COGS are reported at recent purchase prices. Consequently, current earnings will be a more reliable estimate of true profitability and a better starting point for future earnings estimates.

-When prices are rising, COGS reported under FIFO are distorted and will be lower than COGS reported under LIFO. As a result, earnings reported under FIFO will be higher than under LIFO and will not be as useful in estimating future earnings as LIFO earnings would be when prices rise.

-AVCO COGS earnings figures lie between LIFO and FIFO methods. Earnings reported under AVCO cost suffer from the same overestimation bias as FIFO, although not as severe.

Effects on Financial Ratios

An analyst should use:

-LIFO values when examining profitability or cost ratios (income statement) where there are income related figures,

-FIFO values when examining asset or equity ratios (balance sheet)

Profitability Ratios

1. LIFO gives a more accurate value for COGS

2. FIFO understates COGS
-Gross and net profit margins will be over-stated

Liquidity: Working Capital Ratios

1. FIFO gives a more accurate value of inventory since FIFO produces ending inventory figures that are higher and a better measure of economic value or current/replacement cost

2. LIFO understates inventory because working capital reports outdated costs and have little relevance to the economic value of the ending inventory.
-Current ratio understated
-Liquidity ratios should be restated to FIFO

Activity Ratios (Inventory Turnover)

-FIFO gives a more accurate value of inventory, convert inventory to FIFO

-LIFO inventory turnover ratios are meaningless due to mismatching of costs (numerator contains current costs - good, while denominator contains outdated historical costs - bad)

-The preferred method for computing inventory turnover using "current cost," combines two methods, using LIFO COGS in numerator and FIFO inventory balances in the denominator

Inventory Turnover... analyst implication

Given that LIFO produces a better (higher) estimate of COGS, while FIFO produces a better (higher) estimate of ending inventory, analysts prefer to compute inventory turnover on a current cost basis by dividing COGS under LIFO by average inventory measured by FIFO

Solvency ratios:

-The use of FIFO produces a higher inventory (LIFO lower inventory balances)
-FIFO COGS produces higher income versus (Lower FIFO COGS) LIFO.
-Leverage ratios such as total debt ratio and debt to equity ratio will be lower under FIFO because the denominator under FIFO is higher.
-Equity is higher due to higher income that comes from higher retained earnings
-LIFO understates inventory and earnings
-D/E = long term debt/total equity and D/TA are overstated using LIFO

Solvency and Leverage Ratios (analysts implication)

In analyzing firms that use LIFO, the analyst should adjust equity on the Balance Sheet by adding the LIFO reserve to LIFO inventory balance, add LIFO reserve x (1-t) to retained earnings and LIFO reserve x tax rate to the deferred tax liability (DTL)

Cash Flow

Cash flow will be higher under LIFO than cash flow under FIFO because under LIFO COGS, costs are higher, taxable income is less and the resulting taxes are less, ultimately leading to higher CFO under LIFO COGS

PROFITABILITY COMPARISON

LIFO: LOWER
FIFO: HIGHER
IDEAL CHOICE: LIFO

LIQUIDITY COMPARISON

LIFO: LOWER
FIFO: HIGHER
IDEAL CHOICE: FIFO

TURNOVER COMPARISON

LIFO: HIGHER
FIFO: LOWER
IDEAL CHOICE: LIFO FOR COGS, FIFO FOR INVENTORY

DEBT/EQUITY COMPARISON

LIFO: HIGHER
FIFO: LOWER
IDEAL CHOICE: FIFO

CASH FLOW COMPARISON

LIFO: HIGHER
FIFO: LOWER
IDEAL CHOICE: METHOD THAT THE COMPANY IS USING

Declines in the LIFO reserve

-Stable or rising prices with increasing inventory quantities are typically what a business experiences, generally as a result the LIFO reserve does not decline
-LIFO Liquidation refers to a declining inventory balance for a company using LIFO. In this case, the input prices for goods that are being sold are no longer assigned recent prices. These costs can be many years out of date ,causing COGS to appear very low and profits artificially high.

-Using LIFO costs no longer approximates current costs

The LIFO reserve will decline if...

1. Inventory quantity declines
2. Prices are falling

LIFO Liquidations Remaining Details

The higher income resulting from LIFO liquidations (lower COGS being costed) translates into:
-Increased income taxes
-Lower operating cash flows since taxes that were postponed through the use of LIFO are reversed and now paid

-Typical causes for LIFO liquidations include strikes, recession or declining demand for a product line.
-Ironically, this results in firms showing high profits during economic downturns!

we need to be able to "adjust" between LIFO and FIFO in order to:

1. Eliminate differences between firms due to accounting choices so any differences reflect economic variations not accounting distortions

2. Obtain measures most relevant for analytical purposes in computing financial ratios

when prices are rising, LIFO PRODUCES:

1. Higher COGS
2. Lower gross margin
3. Lower operating margins
4. Lower net profit margin

-Given rising prices, LIFO is a better measure of economic cost.
-For firms using FIFO, analysts should re-calculate profitability ratios using estimates of LIFO COGS

when prices are rising, FIFO produces:

1. produces inventory values that are higher and a better measure of current inventory value

2. FIFO produces higher liquidity ratios, such as the current ratio

-For firms using LIFO, analysts should recalculate liquidity ratios using estimates of FIFO inventory

Activity Ratios and Inventory Method
(inventory turnover)

-With LIFO, numerator reflects current prices; denominator avg inv. reflects historical prices: not useful

-With FIFO, numerator reflects historical prices; denominator reflects current prices: may be more useful than LIFO

-Best method: Use LIFO COGS and FIFO average inventory (called the current cost method)

Solvency Ratios and Inventory Method

-FIFO produces a higher value of equity because of the higher inventory value on the left side of the balance sheet; therefore:

-Under FIFO, the debt ratio and debt-to-equity ratio are lower (and more meaningful)

-Under LIFO, analysts should make adjustments to equity and deferred taxes for the LIFO reserve

LIFO to FIFO Inventory B/S Adjustments

1. If an analyst converts ending B/S inventory from LIFO Inv to FIFO Inv, the LIFO reserve is added to the asset side of the balance sheet.

2. In order to make the balance sheet balance for the adjustment, offsetting adjustments to the liabilities and equity side of the equation are required in order that the balance sheet balance.

3. Since the LIFO reserve represents profits not recognized and lower taxes paid (because LIFO COGS is higher, EBT is lower and taxes are lower under LIFO) the required adjustments are:

-Increase retained earnings by the LIFO Reserve x (1 - tax rate)
-Increase deferred tax account by LIFO Reserve x (tax rate)

Income Statement Adjustments, FIFO to LIFO COGS Conversion

-an analyst may want to adjust COGS to a LIFO basis.
-Our GOAL - to convert income to "current cost income" using LIFO COGS

two reasons for converting FIFO COGS to LIFO COGS:

1. To estimate the impact of price changes on the firm's COGS and subsequently earnings, to separate the price effects from operating effects

2. Compare the firm with other firms in the same industry using LIFO accounting

-Only the adjustment of COGS from FIFO to LIFO is economically relevant since adjustments of inventory balances to LIFO serve no purpose, as LIFO inventory balances values are outdated and meaningless.

Specific Inflation Rate - r

-The inflation rate - r needed for the adjustment is NOT a general producer (PPI) or consumer price index (CPI), but rather should be the "specific" price index appropriate for the firm's input production costs.

The inflation rate can be determined two ways:
1. From industry specifics, identify the commodity price inflation index and apply to the firm's COGS. Many industry indices are available by the government and industry trade publications. Use the spot commodity price for the input factors of production.

2. Alternatively, divide the increase in the LIFO reserve for a competing company in the same industry by that company's beginning inventory level converted to FIFO accounting basis.

Weighted Average Cost to LIFO COGS Conversion

-An analyst can also estimate what the COGS would have been under the LIFO method for a company using the weighted average method.

-The estimate is based on the assumption that the weighted average method always reports inventory values and COGS between values reported under LIFO and FIFO, so the adjustment for the COGS estimate should be half of the adjustment (inflation rate x BI weighted average Inv) used for FIFO accounting

Interpretation of Inventory

-During periods of stable prices, each inventory accounting method will yield the same results for inventory balances, COGS and earnings

-During inflationary periods, the key points to remember are that FIFO will provide a more economically useful estimate of the ending inventory value, and LIFO will provide the most useful estimate of the COGS


In times of rising prices:
FIFO on B/S for inventory values
LIFO in I/S for COGS

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