What is Asset Valuation?

Asset valuation simply pertains to the process to determine the value of a specific property, including
stocks, options, bonds, buildings, machinery, or land, that is conducted usually when a company or asset
is to be sold, insured, or taken over. The assets may be categorized into tangible and intangible assets.
Valuations can be done on either an asset or a liability, such as bonds issued by a company.

Asset Valuation

Asset Valuation – Valuing Tangible Assets

Tangible assets refer to a company’s assets that have a physical form, which have been purchased by an
organization to produce its products or goods or to provide the services that it offers. Tangible assets
can be categorized as either fixed asset, such as structures, land, and machinery, or as a current asset,
such as cash.

Other examples of assets are company vehicles, IT equipment, investments, payments, and on-hand
stocks.

To compute the net tangible assets of a company:

The company needs to look at its balance sheet and identify tangible and intangible assets.

From the total assets, deduct the total value of the intangible assets.

From what is left, deduct the total value of the liabilities. What is left are the net tangible assets or net
asset value.
Consider the following simple example:

Balance sheet total assets: $5 million

Total intangible assets: $1.5 million

Total liabilities: $1 million

Total tangible assets: $2.5 million

In the example above, the total assets of Company ABC equal $5 million. When the total intangible
assets of $1.5 million are deducted, that leaves $3.5 million. After the total liabilities are deducted,
which is another $1 million, only $2.5 million is left, which is the value of the net tangible assets.

Asset Valuation – Valuing Intangible Assets

Intangible assets are assets that take no physical form, but still provide a future benefit to the company.
They may include patents, logos, franchises, and trademarks.

Say, for example, a multinational company with assets of $15 billion goes bankrupt one day, and none of
its tangible assets are left. It can still have value because of its intangible assets, such as its logo and
patents, that many investors and other companies may be interested in acquiring.

Methods of Asset Valuation

Valuing fixed assets can be done using various methods, which include the following:

1. Cost Method

The cost method is the easiest way of asset valuation. It is done by basing the value on the historical
price for which the asset was bought.

2. Market Value Method

The market value method bases the value of the asset on its market price or its projected price when
sold in the open market. In the absence of similar assets in the open market, the replacement value
method or the net realizable value method is used.

3. Base Stock Method

The base stock method requires a company to keep a certain level of stocks whose value is assessed
based on the value of a base stock.

4. Standard Cost Method

The standard cost method uses expected costs instead of actual costs, often based on the company’s
past experience. The costs are obtained by recording differences between expected and actual costs.
To learn more, check out CFI’s Business Valuation Modeling course.

Figure 1. Football field model from CFI’s Business Valuation course

Importance of Asset Valuation

Asset valuation is one of the most important things that need to be done by companies and
organizations. There are many reasons for valuing assets, including the following:

1. Right Price

Asset valuation helps identify the right price for an asset, especially when it is offered to be bought or
sold. It is beneficial to both the buyer and the seller because the former won’t mistakenly overpay for
the asset, nor will the latter erroneously accept a discounted price to sell the asset.

2. Company Merger

In the event that two companies are merging, or if a company is to be taken over, asset valuation is
important because it helps both parties determine the true value of the business.
3. Loan Application

When a company applies for a loan, the bank or financial institution may require collateral as protection
against possible debt default. Asset valuation is needed for the lender to determine whether the loan
amount is covered by the assets as collateral.

4. Audit

All public companies are regulated, which means they need to present audited financial statements for
transparency. Part of the audit process involves verifying the value of assets.

Related Readings

Thank you for reading CFI’s guide to Asset Valuation. CFI offers the Financial Modeling & Valuation
Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep
learning and advancing your career, the following CFI resources will be helpful:

What is inventory valuation

Inventory valuation is an accounting practice that is followed by companies to find out the value of
unsold inventory stock at the time they are preparing their financial statements. Inventory stock is an
asset for an organization, and to record it in the balance sheet, it needs to have a financial value. This
value can help you determine your inventory turnover ratio, which in turn will help you to plan your
purchasing decisions.

To give you an example, if you run a shoe business and you’re left with 50 pairs of shoes at the end of
the year, then you need to calculate their financial value and record it in your balance sheet. Let’s look
at how and why you’ll calculate the value.

Why inventory valuation is important?

Identifying the unsold items is just one step in inventory valuation. You also need a rate that you can
multiply by the quantity to arrive at a final value. You may have paid different prices for these items
throughout the year, so you need to choose a technique to calculate a common rate.

Continuing our previous example, let’s look at your purchases for a particular type of sneakers during
the year:

How will you do the inventory valuation of the unsold stock at the end of the year

At the end of the year, you have 50 pairs of unsold items, but due to the fluctuations in the price of the
product, you’re facing a dilemma as to which rate you should use. Therefore, you need to choose a
technique. In the following section, we will look at the different techniques of inventory valuation and
share some pointers which can help you choose the right technique for your business.

What are the different types of Inventory Valuation Methods

There are three methods for inventory valuation: FIFO (First In, First Out), LIFO (Last In, First Out), and
WAC (Weighted Average Cost).
In FIFO, you assume that the first items purchased are the first to leave the warehouse. In other words,
whenever you make a sale, under FIFO, the items will be subtracted from the first list of products which
entered your store or warehouse.

In LIFO, you make the opposite assumption: that the last items that enter your store are the first ones to
leave.

The WAC method uses the item’s average cost throughout the year. The average cost per unit is
calculated by dividing the total cost by the total number of units purchased during the year.

How to value inventory with different inventory valuation methods

Let’s continue our above example and find out how each of these techniques calculates the value of
your unsold stock.

Inventory valuation by FIFO, LIFO and WAC method

From this table, you can see how the value of your unsold inventory at the end of the year will differ
based on the valuation method that you choose. However, there are two caveats to keep in mind:

In the above example, the FIFO value is more than the LIFO value because you paid more per unit at
the end of the year. However, this is not always the case. If your purchase price drops throughout the
year, the FIFO value will be less than the LIFO value and the WAC value will change accordingly.

If the quantity of items unsold at the end of the year is greater than the first or last order, then the
calculation will be slightly different. For example, if you have 150 unsold items at the end of the year,
then the calculations will look like this:

FIFO: Items bought first will be sold first

Use the newest purchase rate for the number of items included in the newest order, then use the
previous rate for the remaining items.

90 * 35 = 3150 ( All the items purchased in the month of December)

60 * 31 = 1860 ( Remaining items to be valued using the rate from October)

————

Total 5010

————

LIFO: Items bought last will be sold first

Use the oldest purchase rate for the number of items included in the oldest order, then use the next
rate for the remaining items.

100 * 30 = 3000 ( All the items purchased in the month of January)

50 * 31 = 1550 ( Remaining items to be valued using the rate from March.)

————–

Total 4550
—————

WAC: Average cost per unit

150 * 31.5 = 4725 (The average price per unit will remain the same as there is NO change in rate and
quantity purchased)

Here’s a table which summarizes the above working –

FIFO, LIFO and WAC method of valuation in case of unsold stock of 150 units

Which inventory valuation method is the best for your business?

Actually, there is no straight answer to this question. Your inventory valuation technique depends on the
market conditions, and your financial goals for your organization. Here are a few scenarios which can
help you to pin down the best inventory valuation technique for your business.

1. Applying for a loan for business expansion

If you’re planning to apply for a loan, then you will need to keep your stock as collateral. In such cases, it
is preferable if the value of your stock is high, because higher valuation will give more assurance to the
lender. If prices are increasing throughout the year, a FIFO inventory valuation technique will give you a
higher value for closing inventory. If prices are decreasing, a LIFO technique will give you a higher value.
The value of the closing inventory in your balance sheet is one of the factors used by financial
institutions before approving a loan to a company, so the technique that gives you the highest inventory
value will be the best for your company.

2. Attracting investors and keeping shareholders happy

A company with a high profit margin can get a lot of attention from potential investors and keep its
existing shareholders happy. So if you’re looking for a new funding opportunity or if you want to please
your shareholders with good earnings, then FIFO valuation will be beneficial under inflationary market
conditions. Similarly, the LIFO valuation will be a better choice when prices are falling.

To make it clearer, let’s look at the same illustration, but with a new assumption that the sales price/unit
is $20.

Inventory valuation method to attract investors and keep shareholders happy

Because the FIFO method results in a higher gross profit, it will make the company more attractive to
investors.

3. Saving taxes

If you’re looking for ways to cut down on your tax liability, then your inventory valuation technique can
help. Assuming an inflationary situation again, a LIFO valuation technique will save you some money. To
show how, let’s refer to the above example again:

Table showing the working of FIFO, LIFO and WAC; and how they can save taxes

You can see that the tax liability is the highest when you follow the FIFO valuation technique, because
the profit is also highest. Under LIFO, the liability is lower because the profit margin is lower. However,
keep in mind that we’re assuming the prices will go up during the year. During a depression, this
scenario might play out differently.

Summing it up

The concept of inventory valuation can seem a little heavy at first. However, once we break it down and
demonstrate each technique, it gets a lot simpler. That’s exactly what we tried to achieve in this article.
If you got slightly overwhelmed, though, here’s a quick recap of what you need to know:
What Is Inventory Management?

Inventory management refers to the process of ordering, storing and using a company's inventory. This
includes the management of raw materials, components and finished products, as well as warehousing
and processing such items.

For companies with complex supply chains and manufacturing processes, balancing the risks of
inventory gluts and shortages is especially difficult. To achieve these balances, firms have developed two
major methods for inventory management: just-in-time (JIT) and materials requirement planning (MRP).

Some firms like financial services firms do not have physical inventory and so must rely on service
process management.

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Inventory Management

How Inventory Management Works

A company's inventory is one of its most valuable assets. In retail, manufacturing, food service and other
inventory-intensive sectors, a company's inputs and finished products are the core of its business. A
shortage of inventory when and where it's needed can be extremely detrimental.

At the same time, inventory can be thought of as a liability (if not in an accounting sense). A large
inventory carries the risk of spoilage, theft, damage or shifts in demand. Inventory must be insured, and
if it is not sold in time it may have to be disposed of at clearance prices—or simply destroyed.

For these reasons, inventory management is important for businesses of any size. Knowing when to
restock inventory, what amounts to purchase or produce, what price to pay—as well as when to sell and
at what price—can easily become complex decisions. Small businesses will often keep track of stock
manually and determine the reorder points and quantities using Excel formulas. Larger businesses will
use specialized enterprise resource planning (ERP) software. The largest corporations use highly
customized software as a service (SaaS) applications.
Appropriate inventory management strategies vary depending on the industry. An oil depot is able to
store large amounts of inventory for extended periods of time, allowing it to wait for demand to pick up.
While storing oil is expensive and risky—a fire in the UK in 2005 led to millions of pounds in damage and
fines—there is no risk that the inventory will spoil or go out of style. For businesses dealing in perishable
goods or products for which demand is extremely time-sensitive—2019 calendars or fast-fashion items,
for example—sitting on inventory is not an option, and misjudging the timing or quantities of orders can
be costly.

Key Takeaways

Inventory management refers to the process of ordering, storing and using a company's inventory.
This includes the management of raw materials, components and finished products, as well as
warehousing and processing such items.

For companies with complex supply chains and manufacturing processes, balancing the risks of
inventory gluts and shortages is especially difficult.

To achieve these balances, firms have developed two major methods for inventory management: just-
in-time (JIT) and materials requirement planning (MRP).

Inventory Accounting

Inventory represents a current asset since a company typically intends to sell its finished goods within a
short amount of time, typically a year. Inventory has to be physically counted or measured before it can
be put on a balance sheet. Companies typically maintain sophisticated inventory management systems
capable of tracking real-time inventory levels. Inventory is accounted for using one of three methods:
first-in-first-out (FIFO) costing; last-in-first-out (LIFO) costing; or weighted-average costing.

An inventory account typically consists of four separate categories:

Raw materials

Work in process

Finished goods

Merchandise
Raw materials represent various materials a company purchases for its production process. These
materials must undergo significant work before a company can transform them into a finished good
ready for sale.

Works-in-process represent raw materials in the process of being transformed into a finished product.
Finished goods are completed products readily available for sale to a company's customers.
Merchandise represents finished goods a company buys from a supplier for future resale.

Inventory Management Methods

Depending on the type of business or product being analyzed, a company will use various inventory
management methods. Some of these management methods include just-in-time (JIT) manufacturing,
materials requirement planning (MRP), economic order quantity (EOQ), and days sales of inventory
(DSI).

Just-in-Time Management

Just-in-time (JIT) manufacturing originated in Japan in the 1960s and 1970s. Toyota Motor (TM)
contributed the most to its development.1 The method allows companies to save significant amounts of
money and reduce waste by keeping only the inventory they need to produce and sell products. This
approach reduces storage and insurance costs, as well as the cost of liquidating or discarding excess
inventory.

JIT inventory management can be risky. If demand unexpectedly spikes, the manufacturer may not be
able to source the inventory it needs to meet that demand, damaging its reputation with customers and
driving business toward competitors. Even the smallest delays can be problematic; if a key input does
not arrive "just in time," a bottleneck can result.

Materials Requirement Planning

The materials requirement planning (MRP) inventory management method is sales-forecast dependent,
meaning that manufacturers must have accurate sales records to enable accurate planning of inventory
needs and to communicate those needs with materials suppliers in a timely manner. For example, a ski
manufacturer using an MRP inventory system might ensure that materials such as plastic, fiberglass,
wood, and aluminum are in stock based on forecasted orders. Inability to accurately forecast sales and
plan inventory acquisitions results in a manufacturer's inability to fulfill orders.

Economic Order Quantity

The economic order quantity (EOQ) model is used in inventory management by calculating the number
of units a company should add to its inventory with each batch order to reduce the total costs of its
inventory while assuming constant consumer demand. The costs of inventory in the model include
holding and setup costs.

The EOQ model seeks to ensure that the right amount of inventory is ordered per batch so a company
does not have to make orders too frequently and there is not an excess of inventory sitting on hand. It
assumes that there is a trade-off between inventory holding costs and inventory setup costs, and total
inventory costs are minimized when both setup costs and holding costs are minimized.

Days Sales of Inventory

Days sales of inventory (DSI) is a financial ratio that indicates the average time in days that a company
takes to turn its inventory, including goods that are a work in progress, into sales.

DSI is also known as the average age of inventory, days inventory outstanding (DIO), days in inventory
(DII), days sales in inventory or days inventory and is interpreted in multiple ways. Indicating the liquidity
of the inventory, the figure represents how many days a company’s current stock of inventory will last.
Generally, a lower DSI is preferred as it indicates a shorter duration to clear off the inventory, though
the average DSI varies from one industry to another.

Qualitative Analysis of Inventory

There are other methods to analyze inventory. If a company frequently switches its method of inventory
accounting without reasonable justification, it is likely its management is trying to paint a brighter
picture of its business than what is true. The SEC requires public companies to disclose LIFO reserve that
can make inventories under LIFO costing comparable to FIFO costing.2
Frequent inventory write-offs can indicate a company's issues with selling its finished goods or inventory
obsolescence. This can also raise red flags with a company's ability to stay competitive and manufacture
products that appeal to consumers going forward.

Article Sources

Related Terms

Material Requirements Planning (MRP) Definition

Material requirements planning is among the first software-based integrated information systems
designed to improve productivity for businesses.

more

Understanding Economic Order Quantity (EOQ)

Economic order quantity (EOQ) is the ideal order quantity that a company should make for its inventory
given a set cost of production, demand rate, and other variables.

more

Inventory

Inventory is the term for merchandise or raw materials that a company has on hand.

more

What Is Just in Time (JIT)?

A just-in-time (JIT) inventory system is a management strategy that aligns raw-material orders from
suppliers directly with production schedules.

more

What Work-in-Progress Really Means

A work-in-progress (WIP) is a partially finished good awaiting completion and includes such costs as
overhead, labor, and raw materials.