Why high cash flow using LIFO?

CFA Level II
#1

Hi,

Does LIFO result in highe/lower operating cash flow? I thought operating income will be lower under LIFO. So cash flow from operating income will be lower and taxes will be lower too. As per Schweser, LIFO always results in higher cash flow due to less taxes.

Am I missing something here?

Thanks.

#2

Depends on whether inventory cost is rising or falling. Cash flow from operating income will be higher for LIFO in rising cost because of lower tax. IMO

#3

preppie is right. assuming inflation one of the reasons for using LIFO is to reduce taxes. Yes your net income will be lower due to higher COGS and your operating profit EBIT will be lower too. But your cash flow will be higher due to reduced cash taxes. If you recall, you can not use LIFO for taxes unless you also use it for financial reporting. The reason is the IRS does not want to allow companies to take advantage of the obvious reporting loop hole. If they did most companies would report LIFO for taxes and reduce their tax liability then turn around and report FIFO to shareholders and low and behold earnings improved. its the best of both worlds.

#4

Is it always the case that tax savings is higher than opearing income loss due to LIFO?

Let’s assume rising costs, tax 40% and all others same between company-1 & company-2.

Company-1: FIFO, Sales $110, COGS $10

Company-2: LIFO, Sales $110, COGS $100

Leaving all other expenses to 0 for brevity,

Company-1 will have operating cash flow of 60 (operating income) - 40 (tax payments) = 20.

Company-2 will have operating cash flow of 6 (operating income) - 4 (tax payments) = 2.

So, LIFO has less cash flow now.

I am sure my fundamentas have gone wrong. Can somebody correct me please?

Thanks.

#5

Operating Income does not equal Cashflow. The question is asking about Cash Flow, not Operating Income. LIFO and FIFO will have two different effects on your change in Net Working Capital adjustment when going from Earnings to Cashflow, which should mitigate the differences in earnings.

So assuming rising Inventory costs. LIFO will overstate COGS, but your change in Inventory portion of Change in NWC will be greater than FIFO which is Subtracted from Earnings to get to Cash Flow. So the difference between LIFO should only materially effect Earnings and the cashflow from Taxes and not Cash Flow from operations.

#6

To echo what’s been said. First, make sure you make the distinction btw operating income and operating cash flow. You’re that net income will be lower using LIFO, but the differences in net income get washed out in the stmt of cash flows when determining cash flow from operations, so the only difference is the impact on taxes. Thus, LIFO results in higher cash flow simply from taxes. The only way this wouldn’t be the case is if prices decline and therefore FIFO and LIFO essentially flip roles.