Inflation and Financial Statement Analysis - Financial Management

Inflation can cause a number of problems for a financial analyst who is trying to assess the performance of a firm over time and in comparison with other firms in the industry. In particular, inventory profits—short-lived increased profits that occur as a result of the timing of price increases—can make a significant difference in a firm’s reported earnings from year to year.

For example, consider a supply company that buys equipment parts wholesale from the manufacturer for $4.00 each and sells them at a retail price of $5.00 each, realizing a profit of $1.00 per unit. Suppose the manufacturer announces a price increase of $0.50 per unit to $4.50, effective on the first of next month. If the supply company passes the increase on to customers and announces a price increase of its own to $5.50, also effective on the first of next month, it will realize a gross profit of $1.50 on every unit sold that originally cost $4.00.

In other words, the company will make additional profit on the units already in inventory prior to the price increase. Once it begins purchasing parts from the manufacturer at the new price of $4.50 per unit, it will revert to its original $1.00 profit. In the meantime, however, the timing of the price increase will allow the company to enjoy short -lived increased profits, or inventory profits. Most companies do not want to pay income taxes on inventory profits, preferring to use these funds to replenish inventories—especially in inflationary times. Fortunately, there is a way of avoiding or deferring the necessity of reporting these higher profits. The last-in, first-out (LIFO) inventory valuation method assumes that the items a firm uses from inventory are those that were acquired most recently.

Thus, they can be priced out of the inventory based on the most recent inventory acquisition costs. In contrast, the first-in, first-out (FIFO) method of inventory valuation, which assumes that the items a firm uses from inventory are the oldest items in inventory, results in the firm’s having to show a higher profit and therefore pay higher income taxes.

The accounting method used for inventory will affect a firm’s profits and its balance sheet.Hence, any financial ratio that contains balance sheet inventory figures (for example, the total asset turnover ratio) or net income will vary from one firm to another, depending on the firm’s accounting treatment of inventory. Another effect of inflation on financial statements is the tendency for the value of fixed assets to be understated.

Also, to the extent that inflation causes a rise in interest rates, the value of long-term debt outstanding will decline. Thus, a firm will appear to be more financially leveraged in an inflationary period than is actually the case.

Inventory profits and inflation are only two factors that can affect a firm’s reported earnings. Differences in the reporting of earnings, the recognition of sales, and other factors can also make comparisons between firms somewhat misleading. Again, a good financial analyst will always “go behind” the figures stated on a firm’s income statement or balance sheet to find out what is actually occurring within a company.

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