What is Inventory?
Inventory is a current asset account found on the balance sheet consisting of all raw materials, work-in-progress, and finished goods that a company has accumulated. It is often deemed the most illiquid of all current assets, and thus it is excluded from the numerator in the quick ratio calculation.
Determining the balance of Inventory
The ending balance of inventory depends on the volume of sales a company makes in each period. It also depends on the purchases made in the same period.
The formula for this is as follows:
Ending Inventory = Beginning Balance + 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 raw materials, work-in-progress, and finished goods (current assets) is turned into revenue. The cost of these goods flows to the income statement via the Cost of Goods Sold (COGS) account.
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 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 accounting system used affects the value of the account on the balance sheet. Periodic inventory systems determine the LIFO, FIFO, or Weighted Average values at the end of every period, whereas perpetual 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 value. Analysts must reconcile for this difference when analyzing companies using different systems.
Turnover and Accounts Payable
The average inventory balance between two periods is needed to find the turnover ratio as well as the determining the average number of turnover days. In these calculations, either net sales nor 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 the raw materials, work-in-progress, and goods ready for sale.
Accounts payable turnover requires the value for purchases as the numerator. This is indirectly linked to the inventory account, as purchases of raw materials and work-in-progress may be made on credit, and thus the accounts payable account is impacted.
Thank you for reading this guide better understand one of the most important current assets on a company’s balance sheet. CFI’s mission is to help you advance your career. With that goal in mind, these additional resources help you along the way: