Lesson 69 - Beginner accounting course

69. How Inventory Affects Financial Statements

Inventory plays a crucial role in a company’s financial health and directly impacts the balance sheet, income statement, and cash flow statement. Proper inventory management ensures accurate financial reporting and helps businesses maintain profitability.

1. Inventory on the Balance Sheet

Inventory is recorded as a current asset on the balance sheet because it is expected to be sold within a year. The value of inventory depends on the chosen accounting method (FIFO, LIFO, or Weighted Average).

Example:

A business purchases $10,000 of inventory.

• If paid in cash → Cash decreases by $10,000, but Inventory increases by $10,000 (total assets remain unchanged).

• If bought on credit → Accounts Payable increases by $10,000, and Inventory increases by $10,000 (liabilities increase).

2. Inventory on the Income Statement (COGS & Profitability)

When inventory is sold, it moves from the balance sheet to the income statement as Cost of Goods Sold (COGS), which reduces gross profit.

• Higher Inventory Costs → Higher COGS → Lower Profit

• Lower Inventory Costs → Lower COGS → Higher Profit

Example:

A store buys 1,000 units at $5 each and sells 800 units at $10 each.

Impact of Unsold Inventory

• The remaining 200 units ($1,000 worth) stay as inventory on the balance sheet.

• If inventory becomes obsolete or damaged, it must be written off, reducing assets and net income.

3. Inventory and the Cash Flow Statement

Inventory purchases affect a company’s cash flow based on whether they are paid in cash or credit.

4. Inventory Turnover and Financial Health

Inventory turnover ratio shows how efficiently a company sells its inventory.

A high turnover ratio means inventory is selling quickly, while a low turnover ratio may indicate overstocking or weak sales.

Example:

If a business has COGS of $50,000 and an average inventory value of $10,000:

Inventory Turnover Ratio = 50,000 ÷ 10,000 = 5 times per year

5. Key Takeaways

• Inventory is recorded as a current asset on the balance sheet.

• When sold, it moves to the income statement as COGS, affecting gross profit.

• Buying inventory reduces cash flow, especially if overstocked.

• The inventory turnover ratio helps measure business efficiency.

• Poor inventory management can lead to losses, write-offs, and financial misstatements.

Proper inventory management ensures accurate financial reporting, healthy cash flow, and higher profitability.