Reading Financial Reports for Dummies (38 page)

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Specific-identification inventory system:
This system actually tracks the value of each individual product in a company’s inventory. For example, car dealers track the value of each car in their stock by using this method. The net income is calculated by subtracting the cost of goods sold that have been specifically identified from the price at which the items are sold.

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Lower-of-cost or market inventory system:
This system sets an inventory value based on whichever cost is lower: the actual cost of inventory or its current market value. Companies whose inventory values can change numerous times, even throughout a day, most often use this valuation method. For example, dealers in precious metals, commodities, and publicly traded securities commonly use this system.

In most cases, companies use the LIFO, FIFO, or average-costing inventory system. Specific-identification inventory is used only by companies that sell major items in which each item has a unique set of add-ons, such as cars or high-end computers. Therefore, each product has a different cost-of-goods-sold value. The lower-of-cost or market inventory system is used primarily by companies that sell marketable securities and precious metals.

The way a company values its inventory has a major impact on its bottom line.

The reason is that the figure a company uses on its income statement for cost of goods sold depends on the costs it assigns to the inventory it sold during the period covered by that income statement. The inventory’s value shown on the balance sheet is what’s left over and still held by the company, so the
ending inventory’s value
is the value of the goods still held by the company.

This is listed as a current asset on the balance sheet.

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If you’re a company outsider, you won’t be able to get the details needed to calculate the value of the products left in inventory. In fact, many times, only the company insiders directly involved in inventory decision-making have access to cost details. Many companies consider actual inventory costs to be a trade secret, and they don’t want their competitors to know the details.

Nonetheless, understanding what’s behind those numbers and how different inventory methods can impact the bottom line is important for understanding financial reports.

If you’re comparing two companies that use two different methods, you need to take that factor into consideration when doing the comparisons. You can find out in the notes to the financial statements which method a company uses.

To calculate a company’s cost of goods sold, you must know the value assigned to the
beginning inventory
(which is the same as the ending inventory for the previous period and is also the same as the inventory number you find on the balance sheet). The beginning inventory is the number that’s used at the beginning of the next accounting period, so any purchases made during this period are added onto the beginning inventory. Finally, you need to number how much inventory is left at the end of the accounting period, which is called the
ending inventory.
Using those figures, here’s the formula for calculating the cost of goods sold:

1. Find the value of the goods available for sale.

Beginning inventory + Purchases = Goods available for sale
2. Calculate the value of items sold.

Goods available for sale – Ending inventory = Value of items sold Applying Three Inventory

Valuation Methods

To give you an idea of how inventory can impact the bottom line, the following sections use an inventory scenario to take you through the calculations for cost-of-goods value by using the three key methods: average costing, FIFO, and LIFO.

In all three cases, I use the same beginning inventory, purchases, and ending inventory for a one-month accounting period in March.

1. 100 (Beginning inventory) + 500 (Purchases) = 600 (Goods available
for sale)

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2. 600 (Goods available for sale) – 100 (Ending inventory) = 500 (Items
sold)

Three inventory purchases were made during the month:

March 1

100 at $10

March 15

200 at $11

March 25

200 at $12

The beginning inventory value was 100 items at $9 each.

Average costing

Before you can use the average-costing inventory system, you need to calculate the average cost per unit.

100 at $9

=

$900 (Beginning inventory)

Plus purchases:

100 at $10

=

$1,000 (March 1 purchase)

200 at $11

=

$2,200 (March 15 purchase)

200 at $12

=

$2,400 (March 25 purchase)

Cost of goods available for sale = $6,500

Average cost per unit:

$6,500 (Cost of goods available for sale) ÷ 600 (Number of units) = $10.83

(Average cost per unit)

After you know the average cost per unit, you can calculate the cost of goods sold and the ending inventory value pretty easily by using the average-costing inventory system:

Cost of goods sold

500 at $10.83 each

=

$5,415

Ending inventory

100 at $10.83 each

=

$1,083

So the value of cost of goods sold using the average-costing method is $5,415. This is the figure you’d see as the cost-of-goods-sold line item on the income statement. The value of the inventory left on hand, or the ending inventory, is $1,083. This is the number you’d see as the inventory item on the balance sheet.

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FIFO

To calculate FIFO, you don’t average costs. Instead, you look at the costs of the first units the company sold. With FIFO, the first units sold are the first units put on the shelves. Therefore, beginning inventory is sold first, then the first set of purchases, followed by the next set of purchases, and so on.

To find the cost of goods sold, add the beginning inventory to the purchases made during the reporting period. The remaining 100 units at $12 are the value of ending inventory. Here’s the calculation:

Beginning inventory: 100 at $9

=

$900

March 1 purchase: 100 at $10

=

$1,000

March 15 purchase: 200 at $11

=

$2,200

March 25 purchase: 100 at $12

=

$1,200

Cost of goods sold

=

$5,300

Ending inventory:

From March 25: 100 at $12

=

$1,200

In this example, the cost of goods sold includes the value of the beginning inventory plus the purchases on March 1 and 15 and part of the purchase on March 25. Those units remaining on the shelf are from the last purchase on March 25. The cost of goods sold is $5,300, and the value of the inventory on hand, or the ending inventory, is $1,200.

LIFO

To calculate LIFO, start with the last units purchased and work backward to compute the cost of goods sold. The first 100 units at $9 in the beginning inventory end up being the same 100 at $9 for the ending inventory. Here’s the calculation:

March 25 purchase: 200 at $12

=

$2,400

March 15 purchase: 200 at $11

=

$2,200

March 1 purchase: 100 at $10

=

$1,000

Cost of goods sold

=

$5,600

Ending inventory:

From beginning inventory: 100 at $9

=

$900

So the cost-of-goods-sold line item that you find on the income statement is $5,600, and the value of the inventory line item on the balance sheet is $900.

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Comparing inventory methods

and financial statements

Looking at the results of each method side by side shows you the impact that the inventory valuation system has on the net-income statement:

Income Statement

Averaging

FIFO

LIFO

Line Item

Sales

$10,000

$10,000

$10,000

Cost of goods sold

$5,415

$5,300

$5,600

Income

$4,585

$4,700

$4,400

LIFO gives the lowest net-income figure and the highest cost of goods sold.

Companies that use the LIFO system have higher costs to write off on their taxes, so they pay less in income taxes. FIFO gives companies the lowest cost of goods sold and the highest net income, so companies that use this method know that their bottom line looks better to investors.

Results for the inventory number on the balance sheet also differ using these different methods:

Averaging

FIFO

LIFO

Ending inventory

$1,083

$1,200

$900

LIFO users are likely to show the lowest inventory balance because their numbers are based on the oldest purchases, which, in many industries, cost the least. This situation is exactly opposite if you look at an industry in which the cost of goods is dropping in price — then the oldest goods can be the most expensive. For example, computer companies carrying older, outdated equipment can have more expensive units sitting on the shelves if they try to use the Last In, First Out method, even though the units may not be worth anywhere near what the company paid for them.

Determining Inventory Turnover

The big question you should have for any company is how quickly it sells its inventory and turns a profit. As long as a company turns over its inventory quickly, you probably won’t find outdated products sitting on the shelves.

But if the company’s inventory moves slowly, you’re more likely to find a problem in the valuation of its inventory.

You use a three-step process to find out how quickly product is moving out the door.

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Calculating inventory turnover

Here’s the three-step formula for calculating a company’s inventory turnover:
1. Calculate the average inventory (the average number of units held in
inventory).

Beginning inventory + Ending inventory ÷ 2 = Average inventory
2. Calculate the inventory turnover (the number of times inventory is
completely sold out during the accounting period).

Cost of goods sold ÷ Average inventory = Inventory turnover
3. Calculate the number of days it takes for products to go through the
inventory system, according to the accounting policies in the notes to
the financial statements.

365 ÷ Inventory turnover = Number of days to sell all inventory In this calculation, you find out the number of days it takes the company to sell its entire inventory.

I use Mattel’s and Hasbro’s 2007 income statements and balance sheets to show you how to calculate inventory turnover and the number of days it takes to sell that inventory. Both companies use the FIFO inventory system to value their inventory, according to the accounting policy in their notes to the financial statements.

Mattel

1. Find the average inventory.

Use the inventory on hand December 31, 2006, as the beginning inventory, and use the inventory remaining on December 21, 2007, as the ending inventory.

$383,149,000 (Beginning inventory) + $428,710,000 (Ending inventory) ÷ 2

= $405,929,500 (Average inventory)

2. Calculate the inventory turnover.

You need the cost-of-goods-sold figure on the 2007 income statement to calculate the inventory turnover.

$3,192,790,000 (Cost of goods sold) ÷ $405,929,500 (Average inventory) =

7.87 (Inventory turnover)

This figure means that Mattel completely sold out its inventory 7.87

times during 2007.

3. Find the number of days it took for Mattel to sell out all its inventory.

365 (Days) ÷ 7.87 (Inventory turnover) = 46.4

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As an investor reading this report, you can assume that on average, Mattel sells all inventory on hand every 46.4 days. Remember, though, that isn’t true for every toy that Mattel makes. Popular toys may sell out and new stock may be needed every month, whereas less popular toys may sit on the shelf for several months or more. This calculation gives you an
average
for all types of toys sold.

Hasbro

1. Calculate the average inventory.

Use the inventory on hand December 31, 2006, as the beginning inventory, and use the inventory remaining on December 21, 2007, as the ending inventory.

$203,337,000 (Beginning inventory) + $259,081,000 (Ending inventory) ÷ 2

= $231,209,000 (Average inventory)

2. Calculate the inventory turnover.

To do so, use the cost-of-goods-sold number on the 2007 income statement.

$1,576,621,000 (Cost of goods sold) ÷ $231,209,000 (Average inventory) =

6.82 (Inventory turnover)

3. Find the number of days it took for Hasbro to sell off its inventory.

365 (Days) ÷ 6.82 (Inventory turnover) = 53.5

So Hasbro sells its entire inventory every 53.5 days. Mattel is selling its toys faster.

What do the numbers mean?

Hasbro takes more than 50 days to sell all its inventory, and Mattel sells out every 46.4 days. Mattel turns over its inventory about 8 times a year, while Hasbro turns it over around 7 times per year. To judge how well both companies are doing, check the averages for the industry — you can do so online at Bizstats (http://bizstats.com/inventory.htm). Using the stats for Miscellaneous Manufacturing, I find that 8.15 is the average inventory turnover ratio in the industry. So Mattel is slightly below average at 7.87, and Hasbro, at only 6.82, has some room for improvement.