If this business switches to use FIFO, the cost of goods sold will decrease and the ending inventory will increase. So the profit will become higher. Because inventory is under the asset, so in the balance sheet, asset will be higher than before. In addition, the current ratio goes up.
If this business switches to use FIFO, the cost of goods sold will decrease; however, the ending inventory will increase. The result would be a higher profit because inventory is under the asset. In the balance sheet asset will be higher than before. In addiction, the current ratio goes up.
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To understand how switching to FIFO affects the cost of goods sold, ending inventory, profit, asset value, and the current ratio, let's break down each aspect individually:
1. Cost of Goods Sold (COGS): FIFO stands for "first-in, first-out." Under FIFO, the cost of goods sold is calculated by assuming that the oldest (earliest) inventory items are sold first. This method reflects a more realistic representation of a company's operations, particularly for businesses that deal with perishable or time-sensitive goods. If this business switches to FIFO, the cost of goods sold will decrease. This is because older, potentially cheaper inventory items are considered to be sold first, leading to a lower cost of goods sold.
2. Ending Inventory: Similarly, under FIFO, the remaining inventory is composed of the newest (most recent) inventory items. Switching to FIFO will increase the ending inventory because the older, lower-cost items will remain unsold, while the newer, potentially higher-cost items will be counted as part of the ending inventory.
3. Profit: As the cost of goods sold decreases under FIFO, the difference between sales revenue and COGS widens, resulting in higher profits. This is because selling goods at a higher price while considering the lower cost of older inventory items boosts the company's profitability.
4. Asset Value & Balance Sheet: Inventory is considered an asset on the balance sheet. When the ending inventory increases due to switching to FIFO, the value of the inventory asset will also increase because the newer, potentially higher-cost items are counted as part of the ending inventory. This, in turn, raises the overall value of assets on the balance sheet.
5. Current Ratio: The current ratio measures a company's ability to cover its short-term liabilities using its current assets. It is calculated by dividing current assets by current liabilities. Since the ending inventory increases when switching to FIFO, it raises the value of current assets without affecting current liabilities. As a result, the current ratio will likely go up, indicating an improved ability to meet short-term obligations.
To summarize, switching to FIFO in the given business scenario will result in decreased COGS, increased ending inventory, higher profits, increased asset value on the balance sheet, and an improved current ratio. It's important to note that the specific impact may vary depending on the unique characteristics and circumstances of the business.