Getting to Know Your Balance Sheet Inventory
In the previous blog post (January 13, 2023) we started the process of better understanding your balance sheet. The purpose is not to make our readers accountants, but to identify reasons to become familiar with your financial statements so that you can better manage your business. We continue this week with Inventory, another current asset.
Inventory is the value of the company’s raw materials, work in progress, supplies used in operations, and finished goods (if applicable). Inventory is another current asset. They are all likely to be converted into cash, sold, exchanged, or expensed in the normal course of business within a year.
Production Cycle and Working Capital
The company uses its cash to purchase raw materials (inventory). Those materials are transformed with the application of the company’s expertise, labor, and fixed assets (equipment, vehicles, etc.).
As the transformation is completed (usually in phases for construction), the accountant will send an invoice to create an account receivable for the finished project. That cycle is the company’s production cycle and reflects the company’s working capital. The Working Capital is the money the company uses to finance its daily operations. It can be measured by the formula Current Assets – Current Liabilities (short-term debts). Note that this wouldn’t include cash related to non-production activities like PPP receipts.
Valuation of Inventory
How does inventory show up on the balance sheet? In the U. S. the two most widely used methods of inventory valuation are LIFO and FIFO. (Last in, First out) and (First in, Last out) In an inflationary environment, a company’s earnings and taxes will depend on which method it uses. For example, if a company is using FIFO when the accountant records the cost of goods for that project, he will assign the cost at the rate of the first purchases or say $1. If the accountant uses LIFO, he may assign the value of the inventory to the most recent purchase or $1.5. If the sale is $2.00, with
FIFO the company will have earnings and taxes on $.50
LIFO the company will have earnings and taxes on $.25
While the most accurate method may be LIFO, companies can and do use FIFO for various reasons beyond our coverage here. Both are acceptable under GAAP* guidelines.
While service companies like landscaping businesses don’t have large inventories of raw materials like a manufacturer might have, knowing what you have on your balance sheet at the time you are valuing the business can be eye-opening. If the inventory includes materials that are out of date or unusable, it may require an adjustment to that asset on the balance sheet, for example.
If the inventory is accounted for on a FIFO method, the materials purchased earlier at lower costs (in our inflationary months) may tend to show costs at a lower rate than recent purchases may reflect, thus artificially increasing earnings temporarily. At the time of a valuation of the business, inventory is usually adjusted to correct for possible over or understated values. All of this is before the consideration of how the inventory will be accounted for. Accounting for inventory is a complicated subject that can alter the balance sheet, depending on the method used. Inventory Days will measure how long inventory is in stock before it is converted to sales.
Are you digging into your company’s performance measures and evaluating your company’s strengths in readiness for sale? Would you like to discuss what a buyer is looking for and how well your company matches up to those criteria for maximum sale price? Are you wondering if an internal sale is the way to move forward and want to figure out how that would work? We will be happy to have a discussion to help you begin or complete your exit planning process.
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*And by the way, why do we care about GAAP accounting?
While a private company owner can use whatever accounting methods, he/she desires if no one else need understand the company financials, not using the guidelines that are understood and accepted create a hardship that is unnecessary and that will probably be costly. It’s as if you wanted to use an obscure language that most people in the US don’t understand. Imagine how much the translation for every report will cost!
GAAP. Generally Accepted Accounting Principles. The common set of standards and procedures by which audited financial statements are prepared. While most privately held companies do not generate audited financial statements, most do follow GAAP standards (and note when they do not) so that their financial results can be compared to other companies on a (mostly) apples to apples basis. If a company developed its own way of accounting for revenue and costs, a translation would eventually have to be provided if anyone other than its owners wanted to use the financial statements. This would include sources of lending, insurance providers, federal, state and government tax and corporate authorities, managers and ultimately, investors. Footnotes to provide clarity about which choices are made among options are an important part of accounting disclosures.