LIFO vs. FIFO: Understanding the Differences Between Inventory Methods

Guidance for Asset Based Lenders

Author: Robert Krahn, Field Examination Manager

As you know, inventory is probably one of your biggest sources of collateral, if not the biggest source. But you need to be aware of significant differences in the ways your clients report inventory. 

Which method is best? It depends

Under the first-in, first-out (also known as “FIFO”) method, the first units entered into inventory are the first ones sold. With the last-in, first-out (LIFO) method, however, the most recent purchases are the first to be sold.

As time marches on, the choice becomes material, particularly in an inflationary environment. Companies that report inventory using FIFO report higher pretax earnings, lower cost of sales and higher inventory values than otherwise identical companies that use LIFO. What this means is that FIFO borrowers will likely appear stronger on the surface.

But LIFO can be a great way to defer taxes and, in the meantime, improve cash flow due to lower taxes. Using LIFO, however, causes the low-cost items to remain in inventory.  As a result, higher cost of sales generates lower pretax earnings as long as inventory keeps getting bigger. To keep inventory growing, a borrower may want to purchase excessive amounts of inventory just to avoid expensing old cost layers.  

LIFO vs. FIFO

Let’s pretend that one of your clients is a manufacturer and it starts the year with absolutely no inventory. The business produces 100 units at $2 in January and 100 units at $2.50 in February. And the company sells 150 units at $4 in January and February combined.

Under that scenario, revenues would be $600, regardless of which inventory method was used. But the cost of sales would be only $325 under FIFO, compared to $350 under the LIFO method. In other words, the current-year taxable income under FIFO would be $275 vs. $250 under LIFO. And the ending inventory would also be higher under FIFO ($125) than under LIFO ($100).

Apples to oranges

When comparing two borrowers, if you don’t understand which accounting methods are being used to report inventory, you may end up making apples to oranges comparisons. Suppose that two borrowers pledge inventory as collateral but one uses LIFO and the other uses FIFO. Does that mean they both deserve the same credit line?

Another thing to consider: It’s possible that LIFO might eventually be repealed for tax purposes. If this occurs, your borrowers might be required to revalue their beginning LIFO inventory to its FIFO value over a period of years. Doing so would increase their tax liabilities without proportionately increasing their real cash flow. As you can imagine, small borrowers would take on a substantial burden, which in turn could compromise their abilities to service your debt.

For any questions on inventory methods or any other asset based lending issue, contact us here or give us a call at 716.847.2651.