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6 Striking Reasons Why Inventory Valuation Is Essential For Your Business

By May 31, 2019June 17th, 2024Blog9 min read
Inventory Valuation for Business

Inventory valuation provides measurements that are accurate, which are used to make strategic decisions and sound financial statements. A more informed decision can be made related to various aspects involved in the business after carrying out a detailed inventory valuation.

At the end of the accounting year, the stock that stays unused in spite of being in the condition to be utilized is known as inventory. It can be said that inventory is one of the most notable assets of the business.

More often than not, businesses leave out inventory valuation considering other operations far more crucial than this. Valuation has to be one of the major aspects of a business to present itself in good light at the end of the accounting year.

The list given below includes all the reasons as to why the valuation of the inventory is advisable for each and every business.

  1. Determining the Financial Position

Inventory is a part of the profit and loss statement that is put together at the end of the accounting year. Along with this, inventory is also a crucial part of the balance sheet. Not having a precise idea of the calculation of the inventory may portray the business in the wrong light. One mistake a year could affect the business in the long run.

A very commonly known formula is used to calculate the cost of goods sold during the financial year: Inventory at the Start of the Year + Purchases + Direct Expenses – Inventory at Year End.

Calculating the inventory on this basis will give you the idea of the following:

  • The net income of the business will be less if the closing inventory is less.
  • The net income of the business in the accounting year will be less in case the opening inventory value is less.
  • In the accounting period, the net income will be less if the opening inventory is more.
  • In the accounting period, the net income will be more if the closing inventory is more.

Determining the profit or loss in the current year can be evaluated precisely through inventory.

  1. Legal Agreement

Under the Companies Act 2013, it is not compulsory to carry out inventory valuation. But then again, according to the Accounting Standard (AS2), it is mandatory for every business firm to reveal the valuation calculated for each section of inventory. Specifications that are related to the inventory (materials, finished products, etc.) along with the policies that were adopted to carry out the valuation.

  1. Understanding the Cash Flow

Having a safety net is essential in a business, which means the inventory should be kept at a minimum amount, more than required. Calculations on cost basis would be an easy task, say if your intent is to keep X amount worth of inventory stored. On the other hand, using the retail basis would require for you to keep an accurate calculation of the inventory and what it cost. This is because a change in the buying price might have resulted in losses if the price of the finished product was not changed.

  1. Reasoning Liquidity

Inventory is a major part of the capital of a business, which is why it needs to be valuated without any dark spaces so as to calculate the liquid ratio and current ratio to the dot. Only with these ratios can the liquidity of a business can be figured out. Since inventory is not something that businesses hold onto for too long, it can also be known as current assets of the company.

  1. To Sell Business

In a case where the business needs to be sold off, the buyer must be willing to pay for the inventory that is stored for the year. It would be advisable to keep the value of the inventory as high as possible. Relying on the cost basis for the calculation process should work out fine for both the parties. In a situation where the retail basis method is to be used, things might get tricky. This is when experts in the field should be contacted to solve any issues.

The costs related to storing the inventory and the workforce that was hired to maintain it are expenses incurred which shall be included in the calculation of valuation of inventory.

  1. For Taxes

Calculating inventory can benefit in terms of tax cuts. The inventory costs can be written off from the total income while reporting to the IRS (Internal Revenue Service.) In case a business wishes to include the cost of inventory, it can be either of the following:

  • Using a value that is lower, i.e if the amount used to buy the inventory is lower, it shall be added to the tax return, while if the current value of the total inventory is lower, it shall be used for calculation.
  • A thing called “other” will use the retail method through which the inventory cost will be reduced in accordance with the retail markup it is used by the business.

Depending on which method is chosen, the tax deduction will vary, at times drastically.

With a clear idea as to how inventory valuation can be profitable for a business, it is time to move on to how the calculation process can be carried out.

Largely accepted, there are 3 methods that GAAP or Generally Accepted Accounting Principles follow for inventory valuation.

  1. First-in First-out (FIFO)

This method records your inventory in various layers as if it has been stacked. This stack is such that the oldest inventory is at the bottom, and the most recently purchased inventory is stored at the top. Each time an inventory is sold, it is taking off from the bottom. The same is recorded in the balance sheet as the oldest inventory sold first. This doesn’t necessarily mean that the item is really the oldest one physically available.

  1. Specific Identification

A tough one to follow through practically, the method requires a business to keep a tab on every piece of inventory from when it is bought, to when it is sold off. The cost fluctuation is tracked throughout its journey in the business. Serial numbers, projects it is related to, etc. are used excessively due to the ease for a later period. The method is used to keep track of more larger items, instead of the smaller inventory. Highly different uses and feel of the inventory is also taken into consideration while choosing the specific identification method.

  1. Last-in First-out (LIFO)

Except being stacked in the format of oldest to the newest inventory, the LIFO method requires businesses to pick out inventory from the top of the stack instead of the bottom. The inventory placed at the top will need to be recorded as sold first. When the cost is going up because of the most recent item being sold, the LIFO method is used.

Another point to remember while choosing between the FIFO and LIFO method should be that the difference between the calculation of inventory cost is called LIFO reserve, which shows the result based on a business’s income that will be considered taxable, derived through the LIFO method. Neither of the two methods specifies any details about the inventory.

A clearer idea can be established as to what method can and shall be used to carry out the calculation of the inventory valuation, by keeping a record of the inventory.

The method that is picked for the inventory valuation at the end of the accounting year will determine how the balance sheet appears to people. It may seem like an easy task to evaluate the inventory, but the task is serious.

Aspects like getting approval for a loan, determining the sales in the financial year, tax returns, etc. could be highly affected with a simple miscalculation in the valuation of the inventory. The implications could make or break a business in the current market.

Due to various such reasons, it is advisable for all businesses to make sure that each and every item is taken into account before submitting the final valuation sheet.

At the base, there are two methods that could be used to keep track of inventory:

  • The Perpetual Inventory Method in which the buying or selling of an inventory is automatically recorded through a computerized program.
  • The Periodic Inventory Method in which records of inventory are kept up-to-date or the price at which the goods were sold at is recorded on a periodic basis. This means that the periodic method is more of a physical count conducted occasionally, rather than daily.

While the end goal of both the methods is to create an inventory balance sheet in good terms, choosing which method works the best for your business will depend on the industry you belong to.

RNC is a leading valuation consulting firm that holds expertise in the valuation of fixed assets, insolvency, dispute resolution, inventory valuation, financial reporting, statutory compliances, etc. RNC’s clients include publicly traded and privately held companies, banks, insurance companies, audit firms, law firms, insurance advisors, government entities & investment organisations, etc.