FIFO to improve net profit margin and current ratio
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Golf Away Corporation is a retail sport stores carrying golf apparel and equipment. The store is at the end of its second year of operation and is struggling. A major problem is that its cost of inventory has continually increased in the past two years. In the first year of operations, the store assigned inventory costs using LIFO. A loan agreement the store has with its bank, a prime source of financing, requires the store to maintain a certain profit margin and current ratio. The store's owner is currently looking over Golf Away's preliminary financial statements for the second year. The numbers are not favorable. The only way the store can meet the required financial ratios agreed on with the bank is to change from LIFO to FIFO. The store originally decided on LIFO because of its tax advantages. The owner recalculates ending inventory using FIFO and submits those numbers and statements to the loan officer at the bank with the required bank review. The owner thankfully reflects on the available in latitude in choosing the inventory costing.
a. How does Golf Away use of FIFO to improve its net profit margin and current ratio?
b. Is the action by Golf Away's owner ethical?
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Solution Summary
This posting explains the use of FIFO to improve net profit margin and current ratio and gives an opinion on the ethics of doing so.
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a. How does Golf Away use of FIFO to improve its net profit margin and current ratio?
Profit Margin: In an economic environment of rising costs, the use of FIFO results in a lower cost of goods sold than LIFO. If cost of goods sold is lower, then the net income will be higher. A higher net income will improve the profit margin ratio, which is calculated as net income divided by net sales.
Current Ratio: With rising costs, FIFO results in the most recent, higher costs being reflected in ...
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