Business owners need to take care when analysing information displayed in the company’s balance sheets. A statement of the assets, liabilities, and capital of the business, the understanding and interpretation of the balance sheet can have a huge impact on the direction of inventory management and the overall success of the business.
It is extremely important that, when looking at the company balance sheets, you pay careful attention to inventory. In fact, for certain types of businesses, inventory will be one of the most important items to analyse on the balance sheet, providing insight into the success and failures of the business in the past and present, and helping to inform decisions for the business’ future.
In this article, we explain some common methods for analysing inventory on the balance sheet.
Weighted Average Cost
Another method business managers can use to account for inventory on the balance sheets is known as the ‘weighted average method’. To use this method, simply divide the cost of goods the business has available for sale by the number of units for sale. This calculation will give you the weighted-average cost per unit. Through this method, the cost of goods for sale becomes the sum of beginning inventory and net purchases.
This is the method that is used in Unleashed Software
Analysing inventory on the balance sheets successfully can be done in multiple ways. One of the most common ways business managers can use to account for goods on the balance sheet is through the FIFO inventory method, which stands for “first in, first out”. The FIFO method helps to estimate the value of inventory currently on hand at the end of a certain period, as well as the cost of goods sold during that same time.
The main principle of the FIFIO method is the assumption that inventory purchased first is also sold first, and that newer inventory sells after the older inventory. This principle entails that the cost of older inventory is assigned to the cost of goods sold and the cost of newer inventory is assigned to ending inventory. The method is of course not foolproof, and the actual flow of inventory may not align exactly to this first-in, first-out pattern.
A related but opposite method for accounting for inventory on balance sheets is the LIFO inventory method, which stands for the “last in, first out” method. As you can guess, the method is in the name, much like the FIFO system. The LIFO method operates under the assumption that the last item of inventory purchased is the first one sold.
Many companies use LIFO on the basis that the cost of inventory naturally increases over time, where pricing inflation is the norm. The effect of this method is that the cost of the most recently acquired inventory will always be higher than the cost of inventory purchased earlier. So, the ending inventory balance will be valued at earlier costs, and the most recent costs will appear in the cost of goods sold.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.