AFM 212 Week 5 Balance Sheet Analysis - Inventory PDF

AFM 212 Week 5 Balance Sheet Analysis - Inventory professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Evaluate inventory costing methods professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE ...

AFM 212 Week 5 Balance Sheet Analysis - Inventory professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Evaluate inventory costing methods professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 3 Flow of Costs § When inventory is purchased or produced, it is capitalized on the balance sheet. § When the inventory is sold, its cost is transferred from the balance sheet to the income statement as cost of goods sold. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 4 Cost of Goods Sold § The beginning inventory is a carryover from the ending inventory balance of the prior period. § Current period inventory purchases (or manufacturing costs) are added to the beginning inventory balance, yielding the cost of goods (inventory) available for sale. § Goods available are either sold and flow to COGS or the goods remain unsold and are still in inventory at the end of the period. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 5 Gross Profit and Managerial Choice § COGS is deducted from sales to yield gross profit: § If higher cost units are transferred from the balance sheet, then cost of goods sold is higher and gross profit is lower. § If lower cost units are transferred to cost of goods sold, gross profit is higher. § Companies have a choice when it comes to determining the cost of the goods sold and the cost of the inventory remaining on the balance sheet. § Three choices for inventory costing: FIFO, LIFO, and average cost. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE First-In, First-Out (FIFO) § Assume the following inventory records: § The FIFO inventory costing method transfers costs from inventory in the order that they were initially recorded § FIFO assumes that the unsold inventory is the most recently purchased: 200 units @ $150 + 50 units @ $100 = $35,000 OR Goods available for sale $80,000 – COGS $45,000 = professionals go #beyondideas $35,000 SCHOOL OF ACCOUNTING AND FINANCE Last-In, First-Out (LIFO) § Assume the same inventory records as before: § The LIFO inventory costing method transfers the most recent inventory costs from the balance sheet to COGS § LIFO assumes that the unsold inventory is the earliest acquired: 250 units @ $100 = $25,000 OR Goods available for sale $80,000 – COGS $55,000 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE = $25,000 Average Cost § Assume the same inventory records as before: Average cost = $80,000 / 700 units = $114.286 per unit § The average cost method computes the average cost to purchase or manufacture inventory available for sale during the period and applies the average to determine COGS and ending inventory § Ending inventory = 250 units @ $114.286 = $28,571 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 9 Financial Statement Effects of Inventory Costing § Three inventory costing methods yield different gross profit. § FIFO has the lowest COGS and highest Gross profit because FIFO matches older, lower-cost inventory against current selling prices. § In recent years, the gross profit impact from using FIFO has been minimal for companies due to § Lower rates of inflation ( ?????) § Increased management focus on reducing inventory quantities through improved manufacturing processes and better inventory controls professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 10 Balance Sheet Effects § In periods of rising costs, LIFO inventories can be markedly lower than under FIFO. § LIFO balance sheets do not accurately represent the cost that a company would incur to replace its current inventory. § LIFO and FIFO balance sheets are not comparable. § Thus, GAAP requires that firms that chose LIFO, also report (in footnotes) the equivalent FIFO inventory amounts. § e.g. Caterpillar in 2018 reported LIFO versus FIFO differences ―these are called the LIFO reserve. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 11 Cash Flow Effects § Taxes drive the decision to use LIFO. § Caterpillar, for example, has saved $693 million in total taxes over time: § Through 2017, CAT’s cumulative COGS was $1,934 M higher than it would have been had the company used FIFO. § Thus, cumulative gross profit and pretax profit were lower by $1,934 million, which saved taxes AND CASH of $677 M ($1,934 M × 35%) through 2017. § In 2018, LIFO reserve increased by $75 M, which created additional tax savings of $16 M. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE LIFO is prohibited under IFRS § Lack of representational Faithfulness § LIFO results in inventory value on the balance sheets not reflecting the current cost of inventory. § Distortion of Financial Results § LIFO can lead to lower reporting earnings than real financial performance, especially during period of inflation § Inconsistent with Economic reality § LIFO does not match the physical flow of inventory for most businesses. In most industries, the oldest inventory is usually sold first § Non-comparability § The use of LIFO can distort comparisons between companies that use different inventory valuation methods professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Examine inventory disclosures in financial statements. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 14 Lower of Cost or Market (LCM) § Lower of cost or market rule says: if the market value of inventory is less than its cost, “write down” the inventory to its market value. § For example, Home Depot uses FIFO costing method. § At the end of each accounting period, Home Depot compares ending FIFO inventory balance with market value (replacement cost) and writes down inventory if cost is less than market value. § This noncash expense, reflected in COGS, reduces gross profit: professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 15 LIFO Reserve Adjustments § We use the following equation to adjust LIFO to FIFO Inventory: § In general, we make three adjustments to convert LIFO to FIFO on the balance sheet: 1. Increase Inventory by the LIFO reserve 2. Increase tax liabilities by the tax rate applied to the LIFO reserve 3. Increase retained earnings by the difference § For example, to adjust CAT’s 2018 balance sheet from LIFO to FIFO: 1. Increase Inventory by $2,009 million (add the LIFO reserve) 2. Increase tax liabilities by $693 million 3. Increase retained earnings by the difference of $1,316 million (computed as $2,009 million - $693 million). professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 16 LIFO Reserve Adjustments § We use the following equation to adjust LIFO to FIFO COGS: § During the year, the change in the LIFO reserve represents the difference in LIFO vs. FIFO COGS during the current year. § FIFO COGS will be lower, which causes higher pretax profit, higher income tax, and higher net income. § For example, to adjust CAT’s 2018 income statement 1. Decrease Cogs by $75 million (the increase in the LIFO reserve) 2. Increase tax expense by $16 million ($75 million x 21% tax rate) 3. Increase net income by the difference of $59 million (computed as $75 million - $16 million). professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 17 Disclosures for a LIFO Reserve § Because companies can choose among various inventory costing methods, financial statements are not comparable. § Compare CAT to a close foreign competitor Kubota, a company that uses FIFO (only U.S. tax law permits LIFO method): professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 18 LIFO Liquidations § When companies reduce inventory levels, older inventory costs flow to the income statement. These older LIFO costs are often markedly different from current replacement costs. § Assuming an inflationary environment, sales of older pools often boost gross profit as older, lower costs are matched against current selling prices on the income statement. § This event is called a LIFO liquidation. § For example, Rite Aid’s 2019 10-K reports the following: professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 19 Analyst Adjustments 6.1 § Snap-On uses LIFO for its U.S. inventory only because IFRS prohibits LIFO. § To analyze Snap-On, we must first adjust certain balance sheet and income statement items from LIFO to FIFO. § Obtain LIFO reserve from each prior year’s footnotes (10-K). professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 20 Analyst Adjustments 6.1 § To convert LIFO to FIFO remember two key equations: 1. FIFO Inventory = LIFO Inventory + LIFO Reserve 2. FIFO COGS = LIFO COGS − Increase in LIFO Reserve professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 21 Analyst Adjustments 6.1 § For Snap-On the balance sheet effects are bigger than the income statement effects. § This is typical of most companies. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analyze inventories and the related accounts payable professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Analysis of Working Capital Components § Productivity reflected in Asset Turnover § More granular analysis focuses on Inventory, A/R, and A/P 23 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 24 Inventory Turnover and Days Inventory Outstanding § Inventory turnover measures the number of times during the period that the company sells its inventory. § Days inventory outstanding (DIO), measures the number of days required to sell the average inventory available for sale. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 25 Interpreting DIO Analyzing DIO is important for at least two reasons: 1. Inventory quality § Product mix can include more (or less) higher margin inventories that sell more slowly. § A company can change its promotion policies. § A company can realize improvements in manufacturing efficiency and lower investments in direct materials and work-in-process inventories. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 26 Interpreting DIO Analyzing DIO is important for at least two reasons: 2. Asset utilization―companies can optimize inventory with: § Improved manufacturing processes can eliminate bottlenecks and the consequent buildup of work-in-process inventories. § Just-in-time (JIT) deliveries of raw materials to the production line can reduce the level of raw materials and associated holding costs. § Demand-pull production, where raw materials are released into the production process when final goods are demanded by customers instead of producing for estimated demand. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 27 Cash Impacts of DIO § All else equal, a lower DIO is preferable. § As inventory is sold more quickly, DIO drops, and the company realizes more cash flow. § Home Depot’s DIO dropped 4.1 days from 2017 to 2018. § We can calculate the effect on cash flow for Home Depot as follows (∆ refers to “change in”): § By holding inventory for 4.1 fewer days, the company realized a cash inflow of $747.5 million. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 28 Days Payable Outstanding (DPO) § Accounts payable turnover measures the number of payment cycles per period (year). § Days payable outstanding (DPO) is the average length of time that payables are deferred. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 29 DPO at Home Depot § Use COGS adjusted for 53rd week: § Home Depot’s DPO of 39.3 days is slightly longer than the typical 30 day payment term. § Delaying payment to suppliers allows the purchasing company to increase its available cash. § However, excessive delays (called “leaning on the trade”) can damage supplier relationships. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Using Purchase vs using COGS in AP turnover § There is another approach to calculate Accounts Payable Turnover using Purchase. Using Purchase is more accurate as it matches the activity that directly impact accounts payable. However, using COGS is more often because it’s readily available and comparable across firms. COGS can be a good proxy for purchase when inventory level don’t fluctuate dramatically in some industries. professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Cash Conversion Cycles professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE § Buy inventory on credit (accounts payable) § Sell inventories of credit (accounts receivable) § Collect the receivables § Pay the accounts payable 32 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Cash Conversion Cycle Generally, companies prefer a lower cash conversion cycle because then the operating cycle is generating profit and cash flow quickly Our analysis of this measure focuses on trends over time and comparisons to peers (with similar business models) professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Cash Conversion Cycle § Cash conversion cycle depends on business model, which reflects § Credit terms offered to customers § Types of inventory carried and depth and breadth of product lines § Time period in which suppliers are paid for goods and services 34 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE © Cambridge Business Publishers, 2021 35 Cash Conversion Cycle (CCC) § Each time a company completes one cash conversion cycle, it has purchased and sold inventory (realizing sales and gross profit), and paid A/P and collected A/R. § The cycle increases cash flow (unless the sales are unprofitable). § Home Depot’s cash conversion cycle for the past three years: professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Cash Conversion Cycle at Pfizer § Pfizer holds inventory of raw materials, work in process and finished goods for 96 days § Pfizer’s suppliers provide financing for 66 days and customers pay in 41 days § Pfizer’s cash is tied up in inventories and receivables for 71 days which it must finance § A positive cash conversion cycle is the norm for most firms 36 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Cash Conversion Cycle at Apple § Apple carries little inventory, products are pre-sold and shipped when manufactured § Apple has quick collection of sales and relatively longer time to pay suppliers § The negative number means that Apple can invest the cash it receives from product sales for 63 days before that cash is needed to pay suppliers § Apple generates profit from the sale and from investing its cash § A negative cash conversion cycle can be viewed positively 37 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE Pfizer’s Cash Conversion Cycle § Pfizer’s (CCC) improved by 16 days during 2022 as compared to 2021 § It sold its inventories 5 days faster (96 vs 101) § It collected its receivables 3 days earlier (41 vs 44) § It delayed paying its suppliers by 8 days (66 vs 58) § Use changes in each component of CCC to determine cash generated or additional cash used 38 professionals go #beyondideas SCHOOL OF ACCOUNTING AND FINANCE