Question

Question: BTN 5-3 Golf Challenge Corp. is a retail sports store 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, its 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 Challenge’s preliminary financial statements for its 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 for the required bank review. The owner thankfully reflects on the available latitude in choosing the inventory costing method.

Required:

How does Golf Challenge’s use of FIFO improve its net profit margin and current ratio?

Short answer

Answer

The FIFO method will improve the net profit margin and current ratioby decreasing the cost of goods sold and increasing the current ratios.

Step-by-step solution

Definition of Net Profit Margin

Net profit margin is the ratio reflecting the net income of the business entity as a percentage of revenue earned by the business entity.

Improvement in Net Profit Margin

Adopting FIFO for inventory valuation will increase the net profit margin and current ratio for the company due to following reasons:

1. FIFO will report the lower cost of goods sold in the income statement. It is so because the initially acquired units will be sold out first.
2. Under FIFO, recent inventory with higher costs will be included in the ending inventory, increasing the business entity's current assets and current ratio.