Understanding Ratios

Ratios are the bedrock of a great deal of financial analysis. When one of my colleagues chats me up on a stock, I inevitably end up turning to a list of ratios to judge the operational performance of the company and, in turn, judge how affordably the shares are priced.

But unfortunately, ratios aren't always as clean-cut and useful as they appear, especially when making comparisons between companies. In the case of comparisons, ratios can be particularly misleading, because two companies in the same industry may account for similar assets in different ways. For example, one company may account for its inventory on a first-in first-out (FIFO) basis, while others in the industry may use last-in first-out (LIFO). There are other examples as well, but inventory accounting is more than a large enough example to consider.

Similar, but different
A good example of potential discrepancies in ratios can be seen in pharmacies CVS (NYSE:CVS) and Walgreen (NYSE:WAG). The companies operate similar businesses, but CVS uses FIFO to account for its inventory while Walgreen uses LIFO. You may be thinking, "Big deal! How much different can a few ratios be because of one little accounting decision?"

I'm glad you asked, because at times the differences can be surprisingly large. To get started, it helps to consider which line items on the balance sheet and income statement are directly affected by the inventory accounting decision. The inventory line item on the balance sheet is the first obvious metric that is affected. So inventory turns, days inventory outstanding, and the cash conversion cycle are all affected.

But cost of goods sold (COGS) on the income statement is also affected, because with LIFO, the most recently purchased and generally most expensive goods (assuming inflation) go into COGS, while the older goods remain on the balance sheet. For FIFO, the opposite is true -- the oldest, and generally cheapest, goods go into COGS. Assuming that the cost of inventory rises with inflation, as it usually does, using FIFO would lead to a lower reported COGS, and in turn, operating income, taxes, and net income would all be higher. During periods of rising costs (which is most of the time), LIFO makes profitability on the income statement more conservative.

With regard to the balance sheet, the opposite is true. Using FIFO for the inventory line item means that it will contain the most recently purchased and more expensive items that have not yet been sold, whereas using LIFO causes the oldest and generally cheaper goods to sit on the balance sheet. Thus, for the balance sheet, FIFO is the more conservative method. To make up for this discrepancy, companies that use LIFO are required to disclose in a footnote what their inventory balance would have been under FIFO. This amount is known as the LIFO reserve.

Turning back to our example of CVS and Walgreen, let's look at their inventory turns, adjusted to put both companies on the same footing. Ideally, we'd adjust all of the metrics, but for the sake of brevity and my editor's sanity, I'm going to stick with just inventory turns. To keep things simple, I'll use data from each company's most recently filed annual report, even though doing so does not cover exactly the same time period, because the two companies have different fiscal years.

CVS Inventory Turns (FIFO)

Walgreen Inventory Turns (LIFO)

At first glance, it looks as though Walgreen's inventory turns (cost of goods sold divided by average inventories) are far better than CVS's. However, once the numbers are adjusted, we see a different story. For the adjustment process, I'm going to adjust Walgreen's LIFO numbers to FIFO. It is possible to adjust FIFO numbers to LIFO, but adjusting LIFO numbers to FIFO is much easier, because all of the data is provided by a company reporting inventory under LIFO.

First, we'll adjust the inventory balances for the last couple of years to get an updated average inventory under FIFO. To do this, we simply add the LIFO reserve to the ending inventory balance for each of the past two years. Secondly, we'll adjust the COGS for 2005 by taking the difference between the LIFO reserve amount in 2005 and 2004 and adding it to the COGS for 2005.

Walgreen Inventory Turns (adjusted to FIFO)

Once we have adjusted Walgreen's numbers from LIFO to FIFO, we see that the inventory turns for Walgreen (5.1) are still a bit better than those of CVS (4.8) but not nearly as superior as they initially appeared. In addition, as mentioned above, a change to the inventory-turns ratio would affect the cash conversion cycle as well, because inventory turns are an input into the days inventory outstanding calculation.

As if things weren't interesting enough already, there are still other companies that split the difference between LIFO and FIFO and use the weighted average cost of their inventories. A couple of examples are Men's Wearhouse (NYSE:MW) and Motley Fool Hidden Gems/Motley Fool Rule Breakers selection Blue Nile (NASDAQ:NILE).

Final thoughts
All of the above is important, but I caution against making the leap and assuming that profitability ratios are drastically inflated and that the company is up to something sneaky just because it uses FIFO for its inventory accounting. That's not entirely true, because as we've seen for companies with rising costs, LIFO is more conservative on the income statement and FIFO is more conservative on the balance sheet. The difference in accounting methods, therefore, becomes important only when making operating comparisons between companies.

There are other accounting treatments that can affect a company's ratios as well. For example, a company that has a larger proportion of capital leases will often report lower earnings in the near term than a company with operating leases. That results in lower returns on equity (ROE) and assets (ROA). More importantly, a company with capital leases will have those obligations on its balance sheet and thus have a higher debt-to-equity ratio, while the company with operating leases will make only a footnote disclosure regarding its lease liabilities. This is particularly important for retail companies such as Abercrombie & Fitch (NYSE:ANF) and BJ's Wholesale Club (NYSE:BJ) that tend to use operating leases extensively.

For related accounting Foolishness:

• Be Critical of the Cash Flows
• Earnings vs. Cash
• Show Me the Money!

Nathan Parmelee owns shares in Blue Nile but has no financial stake in any of the other companies mentioned. The Motley Fool is investors writing for investors.