Learning Module 6
Analysis of Inventories
Key Outcomes Summary & Practice Problems
What you must be able to do
Curriculum Year: 2026
Describe measurement of inventory at the lower of cost and net realisable value and its implications for financial statements and ratios — including write-downs, reversals, and the effect on activity vs profitability ratios.
Calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies using different inventory valuation methods (FIFO, LIFO, Weighted Average).
Describe presentation and disclosures relating to inventories and explain issues analysts should consider when examining inventory disclosures and other information sources.
1 · Inventory Valuation: Lower of Cost and NRV
Measure at lower of cost and net realisable value (NRV).
NRV = Estimated selling price − Estimated costs to complete and sell.
Assessment done item-by-item or by groups of similar items.
Write-down: if NRV < carrying amount → write down, recognise loss as expense (usually in COGS).
Reversal required: if NRV subsequently increases → must reverse write-down up to the original write-down amount. Reversal reduces COGS.
For non-LIFO/non-retail methods: lower of cost or NRV(aligned with IFRS post-2016).
For LIFO and retail inventory:lower of cost or market, where market = current replacement cost, bounded by upper limit (NRV) and lower limit (NRV less normal profit margin).
Write-down under LIFO targets current replacement cost.
NO reversal of write-downs permitted under US GAAP— any future recovery is reported prospectively only.
Hatsumei Enterprises example (IFRS): Year 1 — cost EUR5.2M, NRV EUR4.9M → write down EUR0.3M to EUR4.9M; recognise EUR0.3M expense. Year 2 — NRV rises EUR0.5M → reverse write-down limited to EUR0.3M (original write-down). Inventory rises to EUR5.2M (cost); reduce COGS by EUR0.3M.
Same under US GAAP (LIFO): Market = current replacement cost EUR4.7M → write down EUR0.5M; Year 2 — NO reversal permitted.
Write-down = Cost − NRV (or market)
Income statement: ↑ Cost of sales (or separate line) → ↓ Gross profit → ↓ Net income
Balance sheet: ↓ Inventory (current asset) → ↓ Total assets → ↓ Equity
Ratio effects:
Profitability ratios (gross margin, net margin): DECREASE (higher expense, lower income)
Liquidity ratios (current ratio): DECREASE (lower current assets)
Activity ratios (inventory turnover, asset turnover): INCREASE (lower asset denominator)
Days of inventory on hand: DECREASE (higher turnover → fewer days)
Debt-to-equity: INCREASE (lower equity from reduced NI)
Reversal (IFRS only) misleads if ignored: if Company A reversed all prior write-downs, this would reduce cost of sales and boost profit in that period. Analysts should strip out reversals when evaluating underlying operating trends.
LIFO least likely to need write-downs: under LIFO with rising prices, inventory on the balance sheet already reflects the oldest (lowest) costs → carrying value is conservatively low → less likely to exceed NRV. Write-downs under LIFO are less frequent and smaller in magnitude.
Agricultural and commodity inventories exception:producers of agricultural/forest products and mineral ores may carry inventories above historical cost at NRV (fair value less costs to sell). Changes in value (up or down) recognised in profit/loss. Mark-to-market also permitted for bullion dealers.
Debt covenant risk: inventory write-downs reduce profit and equity. Companies near covenant thresholds may be reluctant to recognise write-downs. Analysts must assess the adequacy of allowances for obsolescence.
2 · Inventory Cost Formulas: FIFO, LIFO, Weighted Average
The inventory cost formula determines how the total cost of goods available for sale is split between cost of sales (income statement) and ending inventory (balance sheet). The same physical units are sold — only the cost assignment differs.
Oldest inventory sold first. Newest inventory remains on balance sheet.
Rising prices: COGS is low (old cheap units sold); inventory BS value is high (recent expensive units remain). → Higher gross profit, higher taxes.
Allowed under: IFRS and US GAAP.
Balance sheet inventory reflects current replacement values most closely.
Newest inventory sold first. Oldest inventory remains on balance sheet.
Rising prices: COGS is high (recent expensive units sold); inventory BS value is low (old cheap units remain). → Lower gross profit, lower taxes.
Allowed under: US GAAP ONLY. Prohibited under IFRS.
COGS reflects current replacement cost most closely. BS inventory may be severely understated.
Blends cost of all available units. Assigns the same per-unit cost to COGS and ending inventory.
Results are between FIFO and LIFO in most environments.
Allowed under: IFRS and US GAAP.
Useful when units are indistinguishable. Smooths price fluctuations.
IMPACT MATRIX: RISING PRICES, STABLE OR INCREASING QUANTITIES
Financial Statement Item | FIFO vs LIFO | FIFO vs W. Avg | LIFO vs W. Avg |
|---|---|---|---|
Cost of Sales (COGS) | FIFO lower | FIFO lower | LIFO higher |
Ending Inventory (BS) | FIFO higher | FIFO higher | LIFO lower |
Gross Profit / Net Income | FIFO higher | FIFO higher | LIFO lower |
Income Taxes Paid | FIFO higher | FIFO higher | LIFO lower |
Cash Flow (after taxes) | FIFO lower | FIFO lower | LIFO higher |
Gross Profit Margin | FIFO higher | FIFO higher | LIFO lower |
Current Ratio (Liquidity) | FIFO higher | FIFO higher | LIFO lower |
Inventory Turnover (Activity) | FIFO lower | W.Avg between | LIFO higher |
Days of Inventory | FIFO higher | W.Avg between | LIFO |
LIFO Liquidation: When a LIFO company sells more units than it purchases in a period, it dips into older (cheaper) inventory layers. This releases old low-cost inventory as COGS — reducing COGS and temporarily boosting gross profit. This can distort year-over-year comparisons. US companies using LIFO must disclose any material LIFO liquidation amounts.
LIFO Reserve: The difference between inventory valued under FIFO and inventory valued under LIFO is called the LIFO reserve. To convert LIFO inventory to FIFO: FIFO Inventory = LIFO Inventory + LIFO Reserve. To convert LIFO COGS to FIFO: FIFO COGS = LIFO COGS − Increase in LIFO Reserve (for the period).
Inventory turnover = Cost of sales ÷ Average inventory
(or ending inventory; compare consistently across companies)
Days of inventory on hand = 365 ÷ Inventory turnover
(shorter days = faster inventory sold = better, usually)
Gross profit margin = Gross profit ÷ Net revenue
Volvo 2017 example: Inventory turnover WITH allowance = 254,581 ÷ [(52,701+48,287)/2] = 5.04
WITHOUT allowance = 254,775 ÷ [(56,190+51,970)/2] = 4.71
→ Write-downs make turnover appear HIGHER (deceptively better-looking)
Falling prices (deflation) — rules reverse: under deflation, FIFO produces higher COGS (sells newer, cheaper inventory first if prices fall... wait — in deflation, older units cost more). In deflation with falling costs, LIFO gives LOWER COGS (sells newer, cheaper units) → higher gross profit. FIFO COGS reflects older higher costs → lower gross profit. All relationships in the matrix above reverse under deflation.
Company L (LIFO) vs Company F (FIFO) over 5 years of inflation: both companies have identical inventory turnover in Year 1 (base year). By Year 5: Company L turnover = 17.1; Company F turnover = 14.6. LIFO appears more efficient but isn't — the difference is purely from accounting, not operational. Gross profit margins are nearly identical.
FIFO inventory ≈ current replacement value: under FIFO, ending inventory reflects most recently purchased units → closest to current market values. FIFO BS inventory is more informative for balance sheet analysis.
LIFO COGS ≈ current replacement cost: under LIFO, COGS reflects the most recently purchased (and presumably highest-cost) units. LIFO income statement is more economically meaningful for profitability analysis in inflationary environments.
3 · Disclosures, Analyst Adjustments & Inventory Ratios
IFRS required inventory disclosures:
(a) Accounting policy and cost formula used · (b) Carrying amounts by classification (raw materials, WIP, finished goods) · (c) Amount measured at fair value less costs to sell · (d) Amount recognised as expense (COGS) · (e) Amount of write-down recognised · (f) Amount of write-down reversal (IFRS only) · (g) Circumstances leading to reversal · (h) Carrying amount pledged as security
US GAAP additional required: significant estimates related to inventory; material LIFO liquidation amounts. No (f) and (g) as reversals not permitted.
Three Key Inventory-Related Ratios
Ratio | Formula | What It Measures | Interpretation |
|---|---|---|---|
Inventory turnover | COGS ÷ Avg inventory | Times inventory sold during the year | Higher = faster turnover = better efficiency (but could signal inadequate inventory or write-downs) |
Days of inventory on hand | 365 ÷ Inventory turnover | Average days to sell inventory | Lower = faster selling (but too low may mean stock-outs). Compare to peers and historical norms. |
Gross profit margin | Gross profit ÷ Net revenue | % of revenue remaining after COGS | Higher = better (method affects comparison). Luxury products typically higher than staple products. |
Analyst adjustment — converting LIFO to FIFO for comparability:
1. FIFO Inventory = LIFO Inventory + LIFO Reserve
2. FIFO COGS = LIFO COGS − Increase in LIFO Reserve (for the period)
3. FIFO Net Income = LIFO Net Income + Increase in LIFO Reserve × (1 − tax rate)
4. Equity under FIFO = LIFO Equity + LIFO Reserve × (1 − tax rate)
This enables like-for-like comparisons between LIFO users (US) and FIFO users (non-US). Analysts also compare after stripping out valuation allowances to assess underlying cost structure.
Watching inventory classifications over time: rising WIP inventory may signal production bottlenecks or quality issues. Rising finished goods relative to raw materials may indicate demand weakness. Declining raw materials may signal coming production slowdown.
Perpetual vs periodic system matters for LIFO: under perpetual LIFO, inventory layers are liquidated as each sale occurs during the year. Under periodic LIFO, only the year-end balance of purchases is compared to total sales — which may produce different results. For FIFO and specific identification, perpetual vs periodic gives the same result.
Century Chocolate case — inventory turnover = 5.42: COGS 41,043 ÷ average inventory (8,100 + 7,039)/2 = 7,569.5 → 5.42. Uses FIFO for purchased finished goods (IFRS compliant) and weighted average for manufactured goods.
Storage costs in inventory: storage costs are only included in inventory if they are necessary to bring inventory to present location and condition (e.g., during production process). Storage costs for finished goods awaiting shipment to customers are excluded from inventory — these are period costs expensed when incurred.