What is LIFO Liquidation?
LIFO liquidation refers to the practice of selling or issuing of older merchandise stock or materials in a company’s inventory. It is done by companies that are using the LIFO (last in, first out) inventory valuation method. The liquidation occurs when a company using LIFO sells more goods or issues more old stock than it buys.
A Breakdown of LIFO Liquidation
LIFO liquidation can distort a company’s net operating income, which generally leads to more taxable income. In most cases, a company uses the most recent costs when selling inventory items. The fewer the number of purchases made, or items produced, the further the company needs to go into their older inventory.
When they begin selling inventory beyond that most recent purchase, the process is known as liquidation. As the company goes further back into their LIFO layers, they use up their older, lower cost inventory reserves. The process leads to the cost of goods sold (COGS) to decrease and makes gross profits rise, which means more income recorded that can be taxed.
Why LIFO Liquidation Occurs
There are a number of reasons why LIFO liquidation occurs, including:
- A sudden cash flow problem within the company
- An unexpected spike in demand for the goods the company sells
- A lack of more recent inventory (either because of failure/inability to buy or an issue with production)
- The need to relocate or get rid of inventory, most likely due to a desire for storage space for newer and/or more goods that fit in with the wants and needs of consumers
At the end of the day, companies are generally unwilling to match the lower costs for goods from their old inventory with the current higher sales prices because, when put head to head, it means the company shows a larger pool of income that the government can take taxes from. The process eats significantly into the company’s profits and may significantly affect its bottom line.
LIFO liquidation is often reserved, typically, for companies that are either in some type of financial crisis or are trying to keep their warehouses clear for goods they anticipate needing to buy in the future.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: