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LIFO and Cash flow

edited April 2013 in CFA Level II
In periods of rising prices and stable or increasing inventory quantities, a company using LIFO rather than FIFO will report COGS and cash flows which are, respectively:

Answer Both are higher.

The reason given is: LIFO results in higher cash flow because with lower reported income, income tax will be lower.

Problem is I know the answer instinctively unfortunately I still don't understand why the cash flow will be higher, I just can't visual it in my head.
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Answers

  • I'll take a stab. It may not be right, just how I understand it.

    If rising prices, new goods have a higher price.
    If stable or increasing inventory, this means the goods sold are the new goods, so they're more expensive than the average inventory.

    So COGS is higher...
    ...hence net income is lower...
    ...hence you get taxed less...
    ...which results in a higher cash flow.

    Cash flow isn't really affected by COGS or net income since it's all paid for already - the only way it does get affected is the amount of tax you have to pay.
  • edited April 2013
    Sophie said:

    Hi @diya, I'm assuming you get the higher COGS bit which results in lower earnings before tax. As cash outflow due to tax is less in monetary $ terms (since it's usually a % on profit), I suppose that's where the cashflow would be higher than in a FIFO case.

    So cash flow is higher because as a % there is smaller outflow due to the lower tax expense?
  • A simple example to illustrate that:


    For example, in your inventory there are 2 items (each cost $50 and $100).

    You sold 1 item @ $200 with tax 30%.

    With FIFO, your COGS will be $50 and the amount get taxed will be $45.
    Cash Outflow = -$150 (for the goods)
    Taxed = -$45
    Cash Inflow = +$200
    Total = $5

    With LIFO, your COGS will be $100 and the amount you'll get taxed will be $30.
    Cash Outflow = -$150
    Taxed = -$30
    Cash Inflow = +$200
    Total = $20



    Hence, LIFO has higher COGS ($100) and higher cashflow ($20)


    Hope that helps ;)
    ZeeSophiefabianBAHBINTON
  • BAHBINTONBAHBINTON CanadaPosts: 2 Associate

    Brilliant explanation. Thank you!!!

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