Inventory Valuation Scenario Assume that there are two companies identical in ev

Question

Inventory Valuation Scenario

Assume that there are two companies identical in every way except that Company A uses FIFO and Company B uses LIFO to value their inventory. If both companies visited a bank for the purpose of obtaining a loan due to rising inventory costs and the bank made its decision based on the highest net income, which company would be better positioned to obtain the loan? What if the bank made its decision based on the highest cash flows associated with the inventory costing method the company uses? Which company would be better positioned to obtain the loan? Elaborate on your responses.

Explanation / Answer

In the FIFO method, the goods which are bought first are sold first. In the LIFO method, the goods which are bought last are sold first. In a rising price scenario, LIFO wil give a higher cost of goods sold as the goods bought last shall be costlier. The cost of goods sold under FIFO method shall be lower. Thus, if net income is a criteria for giving out the loan, Company A is more likely to get it as it uses the FIFO method.

The inventory method which is chosen by a company impacts its cash flows. Since the net income will be lower under LIFO, it will lead to reduced cash taxes and cash flow will thus be higher. Thus, if highest cash flows is the criteria company B shall be better positioned to get the loan.

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