Inventory

A key current asset account

Inventory

Inventory is a current asset account found under the balance sheet. It is also often deemed the most illiquid of all current assets, thus excluding it from the numerator in the quick ratio calculation. Inventory will include the balance of all raw materials, work-in-progress and finished goods that a company has accumulated. There is an interplay between the inventory account and the cost of goods sold in the income statement.

Determining the balance of Inventory

The ending balance of inventory depends on the amount of sales a company makes in each period. It also depends on the purchases made in the same period. The formula for inventory is as follows:

Ending Inventory = Beginning Inventory + Purchases – Cost of Goods Sold

Higher sales (and thus higher cost of goods sold) leads to draining the inventory account. The conceptual explanation for this is that inventory (asset) is turned into revenue (equity).

Inventory and COGS

Ending inventory is also determined by the accounting method for Cost of Goods Sold. There are four main methods, namely FIFO, LIFO, Weighted-Average and Specific Identification. These all have certain criteria to be applied, and are prohibited under certain accounting standards, but all of them also vary in the value of cost of goods sold.

In an inflationary period, LIFO will generate higher Cost of Goods Sold than the FIFO method. As such, using the LIFO method would generate a lower Inventory balance than the FIFO method. This must be kept in mind when an analyst is analyzing this account.

Periodic and Perpetual Inventory Systems

While this is a more complex accounting concept, the type of inventory system used affects the value of inventory. Periodic inventory systems determine the LIFO, FIFO or Weighted Average values at the end of every period, whereas perpetual inventory systems determine these values after every transaction. Because of the varying time horizons and the possibility of differing costs, use of either system will result in a different inventory value. Analysts must reconcile for this difference when analyzing companies using different systems.

Related Metrics

The average inventory balance between two periods is needed to find inventory turnover. This is also needed to determine inventory turnover days. In these calculations, either net sales or cost of goods sold can be used as the numerator, although the latter is generally preferred as it is a more direct representation of the value of inventory.

Accounts payable turnover requires the value for purchases as the numerator. This is indirectly linked to the inventory account, as purchases affect inventory as well.

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