The choice of inventory valuation method affects the financial statements. The financial statement items affected include cost of sales, gross profit, net income, inventories, current assets, and total assets. Therefore, the choice of inventory valuation method also affects financial ratios that contain these items. Ratios such as current ratio, return on assets, gross profit margin, and inventory turnover also are affected. As a consequence, analysts must carefully consider inventory valuation method differences when evaluating a company’s performance over time or when comparing its performance with the performance of the industry or industry competitors. Additionally, the financial statement items and ratios may be affected by adjustments of inventory carrying amounts to net realisable value or current replacement cost.
Presentation and Disclosure
IFRS requires the following financial statement disclosures concerning inventory:
- the accounting policies adopted in measuring inventories, including the cost formula (inventory valuation method) used;
- the total carrying amount of inventories and the carrying amount in classifications (e.g., merchandise, raw materials, production supplies, work in progress, and finished goods) appropriate to the entity;
- the carrying amount of inventories carried at fair value less costs to sell;
- the amount of inventories recognised as an expense during the period (cost of sales);
- the amount of any write-down of inventories recognised as an expense in the period;
- the amount of any reversal of any write-down that is recognised as a reduction in cost of sales in the period;
- the circumstances or events that led to the reversal of a write-down of inventories; and
- the carrying amount of inventories pledged as security for liabilities.
Inventory-related disclosures under US GAAP are similar to these disclosures, except that requirements (f) and (g) are not relevant because US GAAP does not permit the reversal of prior-year inventory write-downs. US GAAP also requires the disclosure of significant estimates applicable to inventories and of any material amount of income resulting from the liquidation of LIFO inventory.
Inventory Ratios
Three ratios 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 affected by a company’s choice of inventory valuation method. Analysts should be aware, however, that many other ratios are also affected by the choice of inventory valuation method, although less directly. These include the current ratio, because inventory is a component of current assets; the return-on-assets 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.
The inventory turnover ratio measures the number of times during the year a company sells (i.e., turns over) its inventory. The higher the turnover ratio, the more times that inventory is sold during the year and the lower the relative investment of resources in inventory.
A high inventory turnover ratio and a low number of days of inventory on hand might indicate highly effective inventory management. Alternatively, a high inventory ratio and a low number of days of inventory on hand could indicate that the company does not carry an adequate amount of inventory or that the company has written down inventory values. Inventory shortages could potentially result in lost sales or production problems in the case of the raw materials inventory of a manufacturer.
A low inventory turnover ratio and a high number of days of inventory on hand relative to industry norms could be an indicator of slow-moving or obsolete inventory. Again, comparing the company’s sales growth across years and with the industry and reviewing financial statement disclosures can provide additional insight.
The gross profit margin, the ratio of gross profit to sales, indicates the percentage of sales being contributed to net income as opposed to covering the cost of sales.
