How Inventory Management Affects Financial Statements? 4 Ways

Inventory or stock is the goods and materials that a business holds for the ultimate purpose of resale (or repair), and inventory management is a science that specifies the shape and percentage of stocked goods. Inventory could be in the form of raw materials, work in progress, or finished or completed goods.

Since inventory is an important part of any business, its management can affect any of the financial statements. For instance, a low inventory level could lead to delays in deliveries, while an excess in stock could adversely affect your cash flow.

This blog will discuss the ways in which inventory management affects the financial statements of a business.

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Specific Identification

Standard Costing

Retail Method

Gross Profit Method

Moving Average

Different Methods of Accounting for Inventory

There are several methods for accounting for inventory, and each has its own approach to valuing inventory and calculating cost of goods sold (COGS). The choice of method can significantly affect a company's financial statements. The main methods of inventory accounting are:

1. First In, First Out (FIFO):

• Concept: Under FIFO, it is assumed that the first goods purchased (the oldest inventory) are the first ones to be sold.
• Impact: In times of rising prices, FIFO will result in a lower cost of goods sold and a higher ending inventory, which leads to higher net income and higher taxes.
• Usage: This method is commonly used when inventory items are perishable or obsolete quickly, such as food or medicine.

2. Last In, First Out (LIFO):

• Concept: Under LIFO, it is assumed that the most recent goods purchased (the newest inventory) are the first ones to be sold.
• Impact: In times of rising prices, LIFO results in a higher cost of goods sold and a lower ending inventory, which reduces taxable income and taxes.
• Usage: LIFO is not allowed under IFRS, but it is still permitted under U.S. GAAP. It is typically used when companies want to match the most recent costs with current revenue.

3. Weighted Average Cost (WAC):

• Concept: This method calculates the average cost of all inventory items available for sale during the period. The total cost of goods available for sale is divided by the total units available for sale to determine a weighted average cost per unit.
• Impact: The cost of goods sold and ending inventory are based on the weighted average cost, which smooths out fluctuations in inventory costs.
• Usage: WAC is often used when inventory items are indistinguishable from one another or when a company has large volumes of goods, such as in manufacturing or wholesale distribution.

4. Specific Identification:

• Concept: This method tracks the actual cost of each specific item of inventory. It is used when individual inventory items are easily identifiable and can be matched with specific costs.
• Impact: This method is most accurate but is only practical for businesses dealing with high-value items or low-volume, unique goods, such as automobiles, jewelry, or real estate.
• Usage: Common in industries dealing with expensive, distinguishable products.

5. Standard Costing:

• Concept: Standard costing involves assigning a predetermined cost to inventory, rather than using actual costs. Variances between actual and standard costs are recorded and analyzed.
• Impact: It simplifies the accounting process, but companies need to regularly review and update the standard costs to ensure accuracy.
• Usage: Used in manufacturing environments where products are produced in large quantities with predictable costs.

6. Retail Method:

• Concept: This method is typically used by retailers and estimates the ending inventory value by applying the cost-to-retail ratio. The formula involves dividing the cost of goods available for sale by the retail price of goods available for sale.
• Impact: It provides an estimate of inventory values without the need for a detailed physical count of inventory.
• Usage: Often used in industries with large inventories of similar items, such as department stores or supermarkets.

7. Gross Profit Method:

• Concept: The gross profit method is used to estimate the value of ending inventory based on historical gross profit percentages. The formula involves subtracting the cost of goods sold from sales revenue, then adjusting for known purchases during the period.
• Impact: It is a useful method for interim financial reporting or when a physical count of inventory is impractical.
• Usage: Commonly used for estimating inventory in situations where an exact physical count is not feasible.

8. Moving Average:

• Concept: Similar to the weighted average, but this method updates the average cost after each purchase.
• Impact: It provides a dynamic average cost that adjusts based on the most recent purchases, leading to smoother fluctuations in cost of goods sold.
• Usage: Often used in situations where inventory levels are constantly fluctuating.

Each of these methods can significantly affect the reported financial performance and financial position of a company, especially in terms of profitability, taxes, and inventory management. The method chosen should reflect the business's operational nature and the regulatory framework it operates under.

4 Ways in Which Inventory Management Affects Financial Statements

Inventory management plays a crucial role in shaping a company's financial statements. Here are four ways it impacts financial statements:

1. The Income/Profits:

If there are any errors in calculating inventory, there would be cascading effects on COGS, profits, and income. There are several reasons why your inventory might be inaccurate. Some instances include breakage during transit, not adding returned goods to inventory, and old goods which might have to be sold at a discount. In all such cases, you need to adjust your inventory to an accurate value. Understand that using LIFO will have higher COGS and would be more representative of the current economic reality. Hence, profitability will be more accurate, making it a better indicator for forecasting.

2. Cash Flows:

If a business uses FIFO when prices are rising and inventories are also rising, COGS would be low and net income would be higher. As a result, the company would have to pay higher taxes. This would result in a lower cash flow for the firm.

Additionally, businesses that mismanage inventory by overstocking or understocking can cause fluctuations in cash flow. Overstocking leads to unnecessary capital being tied up in inventory, which could otherwise be used for operational needs or investments. Understocking, on the other hand, could lead to lost sales and missed revenue opportunities, negatively impacting cash inflows.

Cash flow forecasting depends heavily on accurate inventory management. Predictable inventory turnover ensures that a company can better anticipate cash needs for purchasing new inventory or paying off suppliers. Proper alignment between inventory purchases and expected sales can improve liquidity and ensure smoother day-to-day financial operations.

3. Balance Sheet:

Changes in inventories and incorrect inventory balances affect your balance sheet, the financial statement that is a snapshot of your company’s worth based on its assets and liabilities. An incorrect inventory balance can result in an inaccurately reported value of assets and owner’s equity on the balance sheet. However, it does not affect liabilities.

Moreover, changes in inventory valuation methods—such as FIFO, LIFO, or weighted average—can lead to variations in asset values reported on the balance sheet. This can affect key financial ratios, such as the current ratio and asset turnover, which investors and creditors often use to assess the financial health of the company.

An inventory write-down due to obsolescence or shrinkage directly reduces the total value of assets. This diminishes the overall equity reflected on the balance sheet, possibly creating the impression of lower financial stability. Regular reconciliation of inventory helps ensure accurate financial reporting and avoids long-term discrepancies.

4. Working Capital:

Since working capital is defined as current assets minus current liabilities, when inventory goes up in the income statement, the working capital would also go up.

An efficient inventory management system ensures that working capital is optimized by balancing inventory levels. Excess inventory unnecessarily increases current assets but doesn’t immediately contribute to revenue, while too little inventory can hurt revenue generation and operational efficiency, reducing overall profitability. Maintaining the right balance is essential for sustaining positive working capital.

Inventory management impacts liquidity, a critical aspect of working capital. Proper turnover ensures that resources tied up in inventory can be converted to cash quickly to pay off short-term liabilities. This flexibility helps businesses maintain financial resilience and adapt to sudden changes in market conditions or unexpected expenses.

Conclusion

The future of inventory management lies in automation, AI-driven analytics, and real-time tracking, which enable businesses to reduce errors, optimize stock levels, and improve decision-making. However, complexities like fluctuating demand, supply chain disruptions, and managing multichannel inventories pose significant challenges. Partnering with third-party providers for call center and related services ensures efficient communication, customer support, and seamless inventory processes.

At Invensis, we deliver advanced inventory management services powered by cutting-edge software to streamline your operations. Our services include inventory tracking, demand forecasting, warehouse management, and seamless integration with ERP systems. With 24/7 call center support, we ensure real-time updates, order accuracy, and superior customer satisfaction. Our tailored solutions help businesses reduce costs, improve efficiency, and stay competitive. By leveraging our expertise, businesses can focus on core operations while we handle the complexities of inventory management.