Last-In, First-Out (LIFO)

Last-In, First-Out (LIFO) is an inventory accounting method where the most recently acquired items are assumed to be sold first. Imagine a woodpile where you stack new logs on top and also take from the top when you need to build a fire. The old logs at the bottom remain undisturbed for a long time. In the world of business, this means the Cost of Goods Sold (COGS) on the income statement reflects the cost of the newest inventory. This is the direct opposite of FIFO (First-In, First-Out), which assumes the oldest items are sold first. The choice between LIFO and FIFO is not just accounting minutiae; it has a real-world impact on a company’s reported Net Income and, crucially, the amount of Taxes it pays. For an investor, understanding LIFO is like having a secret decoder ring for a company's financial statements, allowing you to see a truer picture of its profitability and value.

Think of your local bakery's shelf of artisan bread. The baker puts the freshest loaves, baked this morning, at the front of the shelf. The loaves from yesterday are pushed to the back. When a customer comes in, they grab the first loaf they see—the freshest one. This is LIFO in action. The last loaf “in” to the shelf is the first one “out.” In business terms, a company using LIFO matches its most recent (and often most expensive) costs against its current revenues. The older, cheaper inventory is left sitting on the Balance Sheet, valued at its original, historical cost.

The primary reason a company chooses LIFO is almost always related to taxes, especially in an environment of rising prices.

During periods of Inflation, when costs are steadily increasing, LIFO has a powerful effect:

• Higher COGS: Matching the newest, most expensive inventory costs with revenue leads to a higher COGS.
• Lower Reported Profit: A higher COGS reduces a company's reported Gross Profit and, ultimately, its taxable Net Income.
• Lower Tax Bill: Less reported profit means the company pays less in income tax for the period. This deferral of taxes frees up cash that the company can reinvest in its business.

Example: A steel company buys 100 tons of iron ore in January for $150/ton. In March, it buys another 100 tons, but the price has risen to $180/ton. In April, it sells 100 tons of steel, using 100 tons of ore.

1. Under LIFO: The company assumes it used the March ore. Its COGS is 100 x $180 = $18,000.
2. Under FIFO: The company assumes it used the January ore. Its COGS is 100 x $150 = $15,000.

By using LIFO, the company reports $3,000 less in profit for the period, saving cash on its tax bill.

If prices are falling (Deflation), the opposite happens. LIFO would result in a lower COGS, higher reported profits, and a higher tax bill. For this reason, LIFO is far less attractive when costs are decreasing.

For a value investor, a company using LIFO presents both a challenge and an opportunity. The key is to know where to look in the Financial Statements.

Because LIFO leaves old, low-cost inventory on the balance sheet, the stated value of inventory is often significantly understated compared to its real, current market value. The good news is that companies must disclose this difference. The LIFO Reserve is a figure, found in the footnotes of financial statements, that reveals the difference between the inventory value reported under LIFO and what it would have been under FIFO. True Inventory Value = LIFO Inventory Value + LIFO Reserve This reserve is essentially a hidden asset. A savvy investor like Warren Buffett would mentally add the LIFO reserve back to the company's Book Value (after adjusting for the taxes that would be due if the inventory were sold) to get a more accurate measure of the company's intrinsic worth.

You cannot directly compare the profitability of a company using LIFO with one using FIFO. The LIFO company will almost always look less profitable during inflationary times. To make a fair comparison, you must convert the LIFO company's figures to a FIFO basis. You can approximate this adjustment by using the year-over-year change in the LIFO Reserve.

A major red flag to watch for is a LIFO Liquidation. This occurs when a company sells more inventory than it purchases during a period, causing it to dip into its old, cheap LIFO layers.

• What happens? Old, rock-bottom costs are matched with current, high sales prices.
• The result? A sudden, artificial, and unsustainable spike in reported profits.

This profit is not from operational excellence; it's an accounting illusion. It can often signal that a company is struggling with its supply chain or facing declining demand. Always check the footnotes to see if management has disclosed a LIFO liquidation—it's a sign that the high-quality earnings you thought you saw might just be a mirage.

It's crucial to note that LIFO is permitted under U.S. GAAP (Generally Accepted Accounting Principles) but is banned under IFRS (International Financial Reporting Standards), which are used by most other countries, including those in Europe. Therefore, you will only encounter LIFO when analyzing U.S.-based companies. In summary, LIFO is a tax-driven accounting tool that can make a company's reported profits appear lower and its balance sheet weaker than they truly are. For the undisciplined investor, this is noise. For the diligent value investor, it's an opportunity. By understanding the LIFO reserve and watching for liquidations, you can adjust the numbers to see the true economic reality of the business and potentially find value where others see only confusing accounting.