What is the effect on financial ratios when using LIFO instead of FIFO?

Definition of Effect of LIFO Instead of FIFO

During periods of significantly increasing costs, the LIFO cost flow assumption instead of the FIFO cost flow assumption will have the following effect:

• LIFO results in lower inventory costs on the balance sheet because the latest, higher costs were removed from inventory ahead of the older lower costs
• LIFO means that the cost of goods sold on the income statement will contain the higher most recent costs
• LIFO means that the gross profit, operating income, taxable income, income taxes paid, and retained earnings will be lower because of the higher cost of goods sold

Examples of Effect on Financial Ratios from LIFO Instead of FIFO

When there is significantly increasing costs, the following profitability ratios will be smaller under LIFO than FIFO:

• Gross profit
• Profit margin
• Return on assets
• Return on stockholders’ equity

The inventory turnover ratio will be greater when LIFO is used during periods of increasing costs. The reason is that the cost of goods sold will be higher and the inventory costs will be lower using LIFO instead of FIFO.