ANALYSIS OF INVENTORIES

Agenda

• Inventory measurement

• Inflation impact on FIFO – LIFO

• Presentation & disclosure

Inventory measurement
Measurement: Reasonable prudence
IFRS US GAAP
• No LIFO inventory cost flow • LIFO inventory cost flow allowed

• Inventory = min (original cost, net • FIFO approach: Inventory = min (original cost,
NRV)
realizable value – NRV)
• LIFO approach: Inventory = min (original cost,
• NRV = sales price – selling costs
market value)

• Market value MUST BE in the range of: NRV –

normal profit < replacement cost < NRV
Measurement: Reasonable prudence
IFRS US GAAP
• Write-down: If original cost < NRV → Inventory • Write-down: same principle as IFRS
written down to NRV, loss reflected in Income but based on min (original cost,
statement (higher COGS or a separate line)
marker value)
• Write-up: After write-down, if inventory value
• NO write-up
recovers → Inventory written up but NOT
above original cost (before write-down), Gain
reflected in Income statement (lower COGS or
a separate line)
Measurement: 1st example
Year 0 Year 1
Original cost 210 210
Selling price 225 235
Selling cost 22 22
Net realizable value 203 213
Replacement cost 197 207
Normal profit 12 12

• What are the per-unit carrying values of Zoom’s inventory using (1)
lower of cost or NRV and (2) lower of cost or market?
Measurement: 1st example
IFRS - Writedown - Year 0 US GAAP - Writedown - Year 0
Original cost 210 Original cost 210
NRV 203 Replacement cost 197
Which value? NRV NRV 203
Inventory value 203 NRV minus NP 191
Write-down 7 Market value 197
Inventory value 197

• Details in the Excel spreadsheet

Measurement: follow-up example
IFRS - Writeup - Year 1 US GAAP - Writeup - Year 1
Previous writedown 7 Writeup amount 0
NRV change 10 Inventory value 197
Writeup amount 7
Inventory value 210

• Details in the Excel spreadsheet

Measurement: Impact on financial ratios
Ratio category Impact of write-down Remarks

Lower current ratio, same quick Lower inventory → lower current assets but
Liquidity
ratio same current liabilities

Lower inventory → lower equity & total asset

Solvency Higher Debt/Equity, Debt/Asset
but same liabilities

Activity Higher inventory turnover Higher COGS but lower inventory

Profitability Lower profit margin Higher COGS, lower gross/operating/net profit

Profit likely to fall at faster pace than Equity and

Efficiency Lower ROE, ROA
Asset
Inflation impacts on FIFO/LIFO
inventory cost flow
FIFO/LIFO: Diagram for inflation & flat/up Inv

Note: FIFO/LIFO reflect inventory COST FLOW, NOT ACTUAL PHYSICAL FLOW OF INVENTORY
FIFO/LIFO: Comparison of impacts
FIFO LIFO
• Lower COGS → higher profit → higher • Higher COGS → lower profit → lower
income tax → lower cash flow income tax → higher cash flow

• Higher ending inventory value • Lower ending inventory value

• Most updated inventory value • Most outdated inventory value

Note: The above impacts are reversed if the environment is deflationary

FIFO/LIFO: Comparison of impacts (2)
Ratio category Impact of FIFO Impact of LIFO

Liquidity Higher current ratio, same quick ratio Lower current ratio, same quick ratio

Solvency Lower Debt/Equity, Debt/Asset Higher Debt/Equity, Debt/Asset

Activity Lower inventory turnover Higher inventory turnover

Profitability Higher profit margin Lower profit margin

FIFO/LIFO: LIFO liquidation
• LIFO Liquidation occurs when LIFO inventory quantities decline and older/lower-cost
inventory are thus included in the COGS

• Impact of LIFO liquidation: Because of lower COGS, profits rise faster than normal pace
→ “artificially” better earnings figures

• Why “artificially”? Profit increases are UNSUSTAINABLE as lower-cost inventory

quantities will be depleted soon (assuming no inventory replenishment)
FIFO/LIFO: An example
Year 1 Year 2 Year 3

Sales price 100 105 110

Purchase price 80 84 88

Sales volume 10,000 12,000 16,000

Beginning inventory quantity 0 4,000 7,000

Addition (purchased) 14,000 15,000 10,000
Reduction (sold) 10,000 12,000 16,000
Ending inventory quantity 4,000 7,000 1,000
• Calculate ending inventory value, COGS and gross profit for each year under
FIFO and LIFO cost flow method
FIFO/LIFO: An example
Year 1 Year 2 Year 3
FIFO cost flow
Beginning inventory value 0 320,000 588,000
Addition (purchased) 1,120,000 1,260,000 880,000
Reduction (sold) - COGS 800,000 992,000 1,380,000
Ending inventory value 320,000 588,000 88,000

Revenue 1,000,000 1,260,000 1,760,000

COGS 800,000 992,000 1,380,000
Gross profit 200,000 268,000 380,000
Gross margin 20.0% 21.3% 21.6%

• Details in the Excel spreadsheet

FIFO/LIFO: An example
Year 1 Year 2 Year 3
LIFO cost flow
Beginning inventory value 0 320,000 572,000
Addition (purchased) 1,120,000 1,260,000 880,000
Reduction (sold) 800,000 1,008,000 1,372,000
Ending inventory value 320,000 572,000 80,000

Revenue 1,000,000 1,260,000 1,760,000

COGS 800,000 1,008,000 1,372,000
Gross profit 200,000 252,000 388,000
Gross margin 20.0% 20.0% 22.0%

• Details in the Excel spreadsheet

Quiz Time (1)
Quiz Time (1)
Quiz Time (1)
Inventory presentation &
disclosure
Info sources for inventory analysis
• (Foot)notes to financial statements: original cost – total & by category,
cost flow method, write-down (up), inventory value pledged as collateral

• Company management discussion & analysis

• Peers management discussion & analysis

• Industry experts/forum/conferences
Forensic ideas from category data
Relative growth
(vs total Interpretation - Negative Interpretation - Positive
inventory)
Over-order due to poor Materials hoarding to prepare for surge in
Raw materials
planning/decision-making end demand/potential input shortage
Production machinery issues
Work-in- Increased production to meet robust end
Factory warehouse over-capacity
progress (WIP) demand/prepare for equipment repair
(short-term)
Weak/below expectations sales and Increased production to meet robust end
Finished goods
end demand demand/prepare for equipment repair

Down/(up)side Inventory write-down Reversal of previous write-down (if any)

• Assuming inventory value by category rises faster than total inventory

• Relative growth compared to recent industry/peers data and/or historical performance of the
subject company
Forensic ideas from inventory ratios
• Strong demand for company products • Strong demand for company products &
Relative inventory turnover

but inventory shortage efficient inventory management

• Muted demand for company products • But beware inventory shortage
and (pro)active de-stocking

• Muted demand for company products & • Strong demand for company products &
poor inventory management conservative inventory mgt style
• Risk of excessive inventory • But beware excessive inventory

Relative sales growth

• Relative growth/inventory turnover compared to recent industry/peers data and/or historical

performance of the subject company
Inventory analysis example
Balance Sheet 20X5 20X6 20X7 Inventory breakdown
Current assets 1,970 3,670 5,995 20X5 20X6 20X7
Cash 950 1,250 2,675 Raw material carrying value 120 207 68
Trade receivables 520 1,520 3,020 Allowance (20) (27) (2)
Inventories 500 900 300 Net carrying value 100 180 66
Long-term assets 3,200 2,420 1,750
Total assets 5,170 6,090 7,745 WIP carrying value 50 95 31
Allowance 0 (5) (1)
Short-term liabilities 720 866 1,505 Net carrying value 50 90 30
Long-term liabilities 1,800 1,850 2,150
Equity 2,650 3,374 4,090 Finished goods carrying value 403 706 221
Total sources of fund 5,170 6,090 7,745 Allowance (53) (76) (17)
Income Statement 20X5 20X6 20X7 Net carrying value 350 630 204
Net sales 5,300 5,500 7,500
COGS 2,600 4,100 Total net carrying value 500 900 300
Gross profit 2,900 3,400
Opex 1,900 2,150
• Calculate inventory turnover & days of inventory;
Operating profit 1,000 1,250
sales growth & gross margin; current & quick
ratio; give some forensic ideas on inventory
Inventory analysis example
20X6 20X7 Inventory breakdown % +/-
COGS 2,600 4,100 20X5 20X6 20X7 20X6 20X7
Average inventory 700 600 Raw material carrying value 120 207 68 73% -67%
Inventory turnover 3.7 6.8 Allowance (20) (27) (2) 35% -93%
Days of inventory 98.3 53.4 Net carrying value 100 180 66 80% -63%

Sales growth 3.8% 36.4% WIP carrying value 50 95 31 90% -67%

Gross margin 52.7% 45.3%
Allowance 0 (5) (1) -80%
Net carrying value 50 90 30 80% -67%
Current ratio 2.7 4.2
Quick ratio 2.0 3.2
Finished goods carrying value 403 706 221 75% -69%
Allowance (53) (76) (17) 43% -78%
Net carrying value 350 630 204 80% -68%

Total net carrying value 500 900 300 80% -67%

• Details in the Excel spreadsheet

Inventory analysis example
• Strong demand for company product
but potential inventory shortage &
higher input prices on (i) strong sales
Relative inventory turnover

growth, (ii) fast-declining carrying

value & modest valuation allowance,
(iii) lower gross margin
• What next then?

Relative sales growth

Inventory analysis example
Next steps
• Discuss with top management on input procurement/stocking practices
& supply chain issues (if any), input price trends and end demand

• Cross-check with (global/regional/local) peers & industry experts

Quiz Time (2)
Quiz Time (2)