Net operating cash flow and LIFO/FIFO

CFA Level II
#1

Doing the curriculum reading on lifo/fifo and a bit confused by the solution to #4 listed on curriculum page 16.

The reading claims the only change to NOCF is from lower taxes, but doesn’t the change in COGS due to different inventory accounting change EBT as well thus making it a change in EBT as well as tax expense that one should be listing?

#2

There will be impact only from the changes in the tax paid on the operating cash flows.

Let’s consider two scenarios for a company who started the business with zero inventory in last year. The income statements are for the last year :

Scenario 1:

Revenue = 100

COGS = 60 (Using FIFO) (Ending inventory = 40)

Gross Profit = 40

SG&A = 20

EBIT = 20

I = 0

EBT = 20

Tax = 8 (40%)

NI = 12

Scenario 2:

Revenue = 100

COGS = 70 (Using LIFO) (Ending inventory = 30)

Gross Profit = 30

SG&A = 20

EBIT = 10

I = 0

EBT = 10

Tax = 4 (40%)

NI = 6

Now, CFO under scenario 1 = NI + NCC - Change in working capital = 12 + 0 - 40 (due to ending inventory) = -28

CFO under scenario 2 = 6 + 0 - 30 = -24.

The difference is due to the tax payments only. The differences in COGS has been exactly countered by the differences in ending inventory. That’s why that is not included.

#3

You still have to pay for the inventory no matter how you account for it

#4

The cash flows are:

  1. Paying for stuff (inventory) you buy
  2. Getting paid for stuff you sell
  3. Paying taxes on the profits from selling stuff

Number 1 is the same irrespective of the cost method (FIFO, LIFO, average cost, specific identification) you use for inventory.

Number 2 is the same irrespective of the cost method (FIFO, LIFO, average cost, specific identification) you use for inventory.

Number 3 can change from one inventory method to another.

#5

Thanks guys – very helpful (and clearly been a while since I was doing level 1)!!!