Analysis of Inventories - Financial Statement Analysis | CFA® Level 1 Guide

Inventory Valuation

Learning Outcome Statement:

describe the measurement of inventory at the lower of cost and net realisable value and its implications for financial statements and ratios

Summary:

Inventory valuation under IFRS and US GAAP involves measuring inventory at the lower of cost and net realizable value, with specific differences in treatment such as the allowance for write-down reversals under IFRS but not under US GAAP. The valuation impacts financial statements by affecting the carrying amount of inventory, cost of sales, and subsequently, various financial ratios such as profitability and liquidity ratios.

Key Concepts:

Lower of Cost and Net Realizable Value

Inventories must be recorded at the lower of the cost to acquire or produce the inventory and the net realizable value, which is the estimated selling price minus the estimated costs to complete and sell the inventory.

Write-downs and Reversals

A write-down reduces the recorded cost of inventory to reflect a loss in value, recognized as an expense. Under IFRS, if the reasons for a previous write-down no longer exist, the amount can be reversed up to the amount of the original write-down. US GAAP does not allow such reversals.

Impact on Financial Ratios

Inventory write-downs decrease the carrying amount of inventory, affecting profitability ratios negatively by increasing the cost of goods sold. However, they can positively impact activity ratios like inventory turnover because they reduce the denominator in these calculations.

Disclosure Requirements

Financial statements must disclose the accounting policies for measuring inventories, total carrying amounts, any write-downs or reversals, and the circumstances that led to those adjustments. This helps in assessing the impact of inventory valuation on financial health and compliance with accounting standards.

Formulas:

Inventory Turnover Ratio

\text{Inventory Turnover Ratio} = \frac{\text{Cost of Sales}}{\text{Average Inventory}}

This ratio measures how many times a company's inventory is sold and replaced over a period. A higher ratio indicates efficient management of inventory.

Variables:

$Cost of Sales$ :: Total cost associated with the sale of goods in a period
$Average Inventory$ :: Average value of inventory over the period, typically calculated as the average of beginning and ending inventory

Units: times

Presentation and Disclosure

Learning Outcome Statement:

describe the presentation and disclosures relating to inventories and explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information

Summary:

This LOS focuses on understanding how inventories are presented and disclosed in financial statements under IFRS and US GAAP, and the implications these have on financial analysis. It covers the required disclosures, the impact of inventory valuation methods on financial statements and ratios, and how analysts should interpret these disclosures in the context of assessing a company's financial health and operational efficiency.

Key Concepts:

Inventory Disclosure Requirements

IFRS mandates disclosures about inventory accounting policies, total carrying amounts, amounts classified by type, write-downs, and reversals. US GAAP has similar requirements but does not allow for the reversal of inventory write-downs.

Impact of Inventory Valuation Methods

The choice of inventory valuation method (e.g., FIFO, LIFO, weighted average) affects various financial statement items and ratios such as gross profit, net income, and inventory turnover. This choice can significantly influence the financial analysis, especially when comparing companies or assessing trends over time.

Analytical Considerations

Analysts need to consider how inventory valuation methods and related disclosures impact financial ratios and statements. Adjustments to carrying amounts and the effects of write-downs or reversals are particularly crucial in understanding a company's inventory management and overall financial health.

Inventory Ratios

Key inventory ratios include inventory turnover, days of inventory on hand, and gross profit margin. These ratios are affected by the inventory valuation method and provide insights into the efficiency and effectiveness of a company's inventory management.

Formulas:

Inventory Turnover Ratio

\text{Inventory Turnover Ratio} = \frac{\text{Cost of Sales}}{\text{Average Inventory}}

This ratio measures how many times a company's inventory is sold and replaced over a period. A higher ratio indicates more efficient inventory management.

Variables:

$Cost of Sales$ :: Total cost associated with the sale of products in a given period.
$Average Inventory$ :: The average value of inventory over a period, calculated as the average of the beginning and ending inventory.

Units: times per period

Days of Inventory on Hand

\text{Days of Inventory on Hand} = \frac{365}{\text{Inventory Turnover Ratio}}

This metric indicates the average number of days that a company holds inventory before it is sold. Lower days suggest faster inventory turnover.

Variables:

$Inventory Turnover Ratio$ :: The rate at which inventory is sold and replaced during the year.

Units: days

Gross Profit Margin

\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Total Revenue}}

This ratio shows the percentage of revenue that exceeds the cost of goods sold, indicating the efficiency of production and pricing.

Variables:

$Gross Profit$ :: Revenue minus the cost of goods sold.
$Total Revenue$ :: Total income from sales of goods or services.

Units: percentage