LOS K requires us to:
calculate and compare ratios of companies, including companies that use different inventory methods.
The choice of cost flow method (i.e. FIFO or LIFO) does have an impact on the value of inventory and cost of goods sold. Thus, resultantly it also impacts all the ratios that are affected by the value of inventory and cost of goods sold.
Assuming the situation of rising prices, the following would be the impact of the choice of method on the ratios:
1. Profitability Ratios
For the net and gross profit margin ratios, the LIFO technique results in higher COGS, thus a lower net profit. This results in a lower numerator (which is the profit), and the denominator (i.e. net revenues) remains unchanged. Therefore, the profit margin ratios are lower under LIFO, in the situation of rising prices.
2. Liquidity Ratios
For the current ratio, LIFO produces a lower ending inventory, thus the numerator is lesser. Whereas, there is no impact on the denominator as the current liabilities are mostly unaffected. This results in a lower current ratio under LIFO in the case of rising prices.
As far as the quick ratio is concerned, LIFO results in lower profits thus low outflow of cash for the taxation purpose. Therefore, the amount of cash held by the company is higher under the LIFO method, resulting in a higher numerator. This results in a higher quick ratio if the LIFO technique is used.
3. Solvency Ratios
For ratios like the debt-equity ratio, LIFO does not impact the debt, therefore the numerator remains unchanged. However, LIFO also results in lower equity and lower assets due to the lower value of ending inventory, which is a part of the denominator in the ratio. Therefore, the choice of the LIFO technique results in a higher debt-equity ratio in the case of rising prices.
4. Activity Ratios
For inventory turnover ratio, LIFO results in a higher numerator and a lower denominator. This is mainly because LIFO results in a higher cost of goods sold and a lower value of average inventory. Therefore, under LIFO the inventory turnover ratio would be higher in comparison to the FIFO or average cost technique.
For the total assets turnover ratio, LIFO does not make any impact on the numerator. However, it does results in lower total assets, which forms a part of the denominator. Therefore, LIFO results in a higher assets turnover ratio.
Similarly, for the other ratios as well we can analyze the impact of the choice of cost flow technique on the numerator and denominator to understand its impact on the ratios that are affected.