Analyse how the choice of inventory method changes financial ratios
The idea
In a rising-price environment LIFO lowers reported inventory, gross profit, net income and total assets relative to FIFO, and raises cost of goods sold. The ratio consequences run in different directions and must be traced individually: inventory turnover appears higher under LIFO because the numerator is raised and the denominator lowered, while the current ratio and return on assets are depressed by the lower inventory and lower income. Return on equity falls too, but by less than profit alone would suggest, because retained earnings are also lower. Comparison requires converting to a common basis first.
A practice question
In a rising-price environment, which ratio appears higher under LIFO than FIFO?
- The current ratioWhy not: It falls under LIFO, because the understated inventory sits in current assets.
- Inventory turnover — correct
- Return on assetsWhy not: Also falls. Both profit and assets are lower under LIFO, and profit falls proportionally more.
Cost of goods sold is higher and average inventory lower, so the ratio rises from both directions — which makes it look like superior inventory management.
A harder one
Why does inventory turnover appear higher under LIFO when prices are rising?
- Because stock physically moves fasterWhy not: The cost-flow assumption is an accounting choice with no bearing on how quickly goods leave the warehouse.
- Because both parts move the same way — correct
- Because turnover excludes write-downsWhy not: Write-downs are a separate matter and arise under either method. The distortion here comes from the cost-flow assumption itself.
Cost of goods sold is raised and average inventory is lowered at once. Both the numerator and the denominator are distorted in the direction that inflates the ratio, which is why the effect is large rather than marginal.
The hardest tier
A LIFO reporter shows the better inventory turnover and the worse current ratio than a FIFO peer. What is the first step?
- Convert both to a common basis using the LIFO reserve before drawing any conclusion — correct
- Conclude the LIFO company manages stock better but is less liquidWhy not: Both effects follow from the same understated inventory balance. Reading them as two independent findings takes one measurement artefact for two operating facts.
- Discard the current ratio as unreliableWhy not: It is reliable once both companies are on the same basis. The reserve is disclosed so that the adjustment can be made rather than the ratio abandoned.
Two ratios moving in opposite directions is the signature of a measurement difference rather than an operating one, and the reserve is disclosed so it can be removed.
In the app: 12 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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