Loan Collateral: Understanding Inventory and Fixed Assets
Inventory is one of your institution’s biggest sources of collateral. But there are significant differences in the ways your borrowers report inventory. Let’s review the differences between the two common inventory reporting methods of FIFO and LIFO.
Units in Inventory
Under the first-in, first-out (FIFO) method, the first units entered into inventory are the first ones presumed sold. Conversely, under the last-in, last-out (LIFO) method, the last units entered are the first presumed sold.
Over time the choice becomes material, especially in an inflationary environment. Companies that report inventory using FIFO report lower cost of sales, higher pretax earnings and higher inventory values than otherwise identical companies that use LIFO. So, in an increasing-cost market, FIFO borrowers appear stronger — on the surface.
But LIFO can be an effective way to defer taxes and, therefore, improve cash flow. Using LIFO causes the low-cost items to remain in inventory. Higher cost of sales generates lower pre-tax earnings as long as inventory keeps growing.
However, to keep inventory growing, borrowers may be compelled to produce or purchase excessive amounts of inventory to avoid expensing old cost layers.
An Example to Illustrate
Consider a manufacturer that started the year with no inventory. The company produced 100 units at $2 in January and 100 units at $2.50 in February. It sold 150 units at $4 in January and February combined.
Revenues would be $600, regardless of the inventory method used. But the cost of sales would be $325 under FIFO, compared to $350 under the LIFO method.
So the current-year taxable income under FIFO would be $275 vs. $250 under LIFO. Ending inventory also would be higher under FIFO ($125) than under LIFO ($100).
Why Should Lenders Care?
If, when comparing two borrowers, you don’t understand which accounting methods they’re using to report inventory, you may be making apples to oranges comparisons. For example, if two borrowers pledge inventory as collateral but one uses LIFO and the other uses FIFO, and they ultimately have the same bottom line, do both deserve the same credit line?
A LIFO Repeal?
Be aware, the repeal of LIFO for tax purposes has been discussed by Congress. (In addition, international accounting standards being adopted worldwide do not recognize it.)
If a repeal takes place, your borrowers could be required to revalue their beginning LIFO inventory to its FIFO value for tax purposes over a period of years. This would increase their tax liabilities without proportionately increasing real cash flow. For small borrowers, this could be a substantial burden, compromising their abilities to service your debt.