Question

Assume a company uses the FIFO method (first-in, first-out) for inventory valuation while the industry uses the LIFO (last-in, first-out) method. In comparing the company with the industry using ratio analysis, explain which ratios are likely to be affected by this difference and how.

Answer 1

Using the FIFO method in a LIFO industry can lead to inflated financial ratios such as Gross Margin, Inventory Turnover, and Current Ratio, which can misrepresent a company's financial health by not reflecting recent cost increases.

Step-by-step explanation:

When a company uses the FIFO accounting method in a LIFO industry context, it can affect various financial ratios differently in ratio analysis. The primary ratios that might be affected are the Gross Margin Ratio, the Inventory Turnover Ratio, and the Current Ratio. During times of rising prices, FIFO will result in lower cost of goods sold and higher inventory values compared to LIFO, potentially leading to a higher gross margin ratio. In contrast, the inventory turnover ratio could seem artificially high if older, cheaper inventory is being sold. Similarly, the current ratio may be inflated due to higher inventory values affecting current assets.

Ratio analysis under FIFO might show better profitability and liquidity than a LIFO-based analysis, but it might not accurately reflect the effect of recent price increases on inventory costs and might overstate the company's current financial health relative to its LIFO-using competitors.