The impact of "changes in inventories of finished goods and work in progress" on a company's financial analysis

This article addresses the following questions:

• How should financial data be presented to accurately reflect sales revenue?
• What does the term “changes in inventories of finished goods and work in progress” mean in practice?
• When should changes in inventories not be treated as an adjustment to revenue?

Financial analysis is one of the fundamental methods of assessing a company’s performance and one widely used both for internal purposes (as part of the management process) and by the entity's external environment (lenders, investors, business partners, etc.). But should those preparing such analysis uncritically rely on the financial data presented by the entity in its financial statements?

The answer to this question is pretty straightforward: it's advisable to remain on the alert. Only by approaching the data with a healthy dose of skepticism and caution is it possible to make a sound assessment of a company's operations, which in turn supports more effective business decision-making.

Financial statements assessment

When commencing a business analysis of a company, we should first ensure that the financial statements from which we will draw financial data have been prepared correctly. Naturally, making such an assessment requires not only extensive business experience but also a solid accounting background. Fortunately, anyone can form an opinion on this matter by reviewing the auditor's report on the financial statements in question.

If the opinion of the independent auditor does not contain any disturbing information or reservations (or the auditor neither issued an adverse opinion following the statutory audit nor disclaimed an opinion), we can assume that the financial data in question present reliable financial information.

Data presentation method

Another vital issue is the manner in which the entity presents its financial data.

Both the provisions of the Accounting Act of 29 September 1994 (Journal of Laws of 2026, item 522, as amended) and the International Financial Reporting Standards (IFRS) offer various options with regard to choosing measurement methods and presenting business transactions – so that in each case the financial statements faithfully reflect the entity’s financial position and take into consideration the specific nature of its operations.

One of the fundamental choices available to entities is selecting the format of the profit and loss account. This involves deciding between a functional and a nature of expense format (Article 47(4) of the Polish Accounting Act).

Under the functional format, expenses are classified according to their function: e.g., costs of goods sold, general and administrative expenses, selling expenses, etc. This approach directly matches the costs reported in the P&L with the sales revenue generated during the reporting period. 

By contrast, under the nature of expense format, expenses are classified according to their economic nature, including, among others, materials and energy consumed, employee benefits, depreciation and amortisation and external services. Under this approach, all production-related costs incurred during the reporting period are recognised as operating expenses, irrespective of whether the goods produced have actually been sold during that period. In practice, it is often the case that part of the production remains within the company at the reporting date. This is reflected in the balance sheet as either “work in progress” or “finished goods”.

As follows from the above, unless production costs relating to unsold goods are eliminated from the expenses recognised for the period, one of the fundamental accounting principles – the matching principle – would not be satisfied. It is precisely for this reason that the nature of expense P&L includes the line item “changes in inventories of finished goods and work in progress”. This item adjusts production costs and enables the entity to determine its financial result in accordance with the matching principle.

Recognising changes in inventories

If the closing balance of finished goods inventories (together with work in progress) exceeds the opening balance (reflected as a positive amount under "changes in inventories of finished goods and work in progress"), this indicates that the entity incurred production costs during the year for goods that were not fully sold within the reporting period. Consequently, these costs are effectively deducted from operating expenses through the inventory adjustment.

Conversely, where the opening balance of finished goods and work in progress exceeds the closing balance (presented as a negative amount), this indicates that the entity sold products manufactured not only during the current reporting period but also in previous periods. Accordingly, the costs recognised in the current period are increased to reflect the consumption of inventories carried forward from earlier periods¹.

In practice, the item "changes in inventories of finished goods and work in progress" represents the difference between the closing and opening balances of “finished goods” inventories and “semi-finished products and work in progress”.

It should also be noted that, under certain specific accounting systems, the amount reported as changes in inventories of finished goods and work in progress may additionally be affected by movements in accrued and deferred expenses. For the purposes of this article, however, this aspect is not discussed further, as it does not alter the general principles underlying the issue analysed here.

Example of a profit and loss account with a positive change in inventories of finished goods and work in progress

Let us consider a case where an entity prepares its P&L using the nature of expense format. Under this approach, operating expenses include all production costs incurred during the reporting period, irrespective of whether all goods manufactured during that period have actually been sold.

The table above shows that the entity – manufacturing products in year X – incurred operating expenses of PLN 100,000.

To determine the portion of these costs attributable to the products that were manufactured and sold during year X for PLN 130,000, the entity's operating expenses must be adjusted by the amount reported as changes in inventories of finished goods and work in progress. Accordingly, the actual cost of products sold during year X amounts to PLN 80,000 (PLN 100,000 – PLN 20,000).

It should be emphasised that, if only the "unadjusted" revenue and cost of products sold (i.e. excluding the inventory adjustment) were considered, the gross profit on sales would remain unchanged (i.e. PLN 130,000 - PLN 80,000 = PLN 50,000).

Example of a profit and loss account with a negative change in inventories of finished goods and work in progress

Let us now consider the same entity in a reporting period where the changes in inventories of finished goods and work in progress are negative.

For entities preparing P&L using the nature of expense format (also referred to as the classification by nature of expenses), the line item “changes in inventories of finished goods and work in progress” should not be treated as an adjustment to revenue when performing financial analysis.

In this example, the entity incurred operating expenses of PLN 110,000 in year X-1 to manufacture its products. However, the negative balance of changes in inventories of finished goods and work in progress indicates that, in addition to products manufactured during the current reporting period, the entity also sold products that had been manufactured in previous periods.

Consequently, the total production costs attributable to products sold during year X-1 (including products manufactured both in the current and prior reporting periods) amount to PLN 120,000 (PLN 110,000 + PLN 10,000). As in the previous example, once revenue and the cost of products sold during the period are considered on a comparable basis, the gross profit on sales remains unchanged, although the presentation of the financial information differs: (i.e. PLN 140,000 - PLN 120,000 = PLN 20,000²).

The impact of changes in inventories on financial analysis

Now that we understand the nature of changes in inventories of finished goods and work in progress, we can now consider their implications for financial analysis. As illustrated by the preceding examples, this accounting item may have a significant impact on even the most basic comparisons of revenue and expenses, as well as on the calculation of profitability and turnover ratios.

One key point that corporate finance departments should always bear in mind is that, for entities preparing their P&L using the nature of expense format (classification by nature of expenses), changes in inventories of finished goods and work in progress should not be treated as an adjustment to revenue when performing financial analysis³. As explained earlier in this article, this item represents an adjustment to costs, not to revenue. Accordingly, for analytical purposes, it should be reflected within operating expenses rather than sales revenue. 

Example of the impact of changes in inventories of finished goods and work in progress on financial analysis

Drawing from the data presented in the previous examples, let us now examine how changes in inventories of finished goods and work in progress can affect an organisation's financial analysis.

A direct comparison of the financial data reported in the properly prepared P&Ls suggests that sales revenue increased by 15.3%, while operating expenses decreased by 9.1%. However, a closer examination of the individual line items in the simplified P&L reveals that changes in inventories of finished goods and work in progress have adjusted the reported sales revenue in both year X and year X-1.

Example

Having established the economic substance of changes in inventories of finished goods and work in progress, we know that this item actually represents an adjustment to costs, rather than to revenue. Let us therefore reconsider the previous example after making the appropriate presentational adjustments for financial analysis purposes.

We can see here that sales revenue actually increased by 7.1%, rather than by 15.3%, as might have been concluded from analysing the P&L before the relevant adjustments were made.

Likewise, comparing operating expenses before the inventory adjustment may suggest that operating costs declined by only 9.1%, whereas the actual drop in the costs attributable to products sold during the reporting period amounted to 33.3%. In year X, the entity incurred total operating expenses of PLN 100,000. However, only PLN 80,000 of these costs related to products manufactured and sold during that reporting period. The remaining PLN 20,000 represented production costs attributable to inventories remaining on hand and therefore required an inventory adjustment. In year X-1, the entity incurred operating expenses of PLN 110,000. However, the cost of products sold during that year also included operating expenses of PLN 10,000 that had been incurred in previous reporting periods.

It should be emphasised that the adjusted amounts of sales revenue and operating expenses presented above correspond to the figures that would have been reported had the entity prepared its P&L using the functional format. The key conclusion is that meaningful analysis of changes in revenue and expenses – and, consequently, the calculation of financial ratios widely used in financial analysis – should only be undertaken after the underlying financial data have been appropriately adjusted.

The importance of adjusting financial data

The example above demonstrates that, prior to adjusting the P&L data, the gross profit margin for year X would appear to be 33.3%. Following the adjustment, however, the margin increases to 38.5%:

50,000 ÷ 150,000 = 33.3%, and after adjustment 50,000 ÷ 130,000 = 38.5%

Let us analyse the gross profit margin for year X-1 in the same way. The corresponding figures are as follows:

20,000 ÷ 130,000 = 15.4%, and after adjustment 20,000 ÷ 140,000 = 14.3%

From a mathematical perspective, the greater the amount reported as changes in inventories of finished goods and work in progress relative to sales revenue and operating expenses, the greater the potential distortion of the financial ratios used in financial analysis. Conversely, once the economic substance of this accounting item is properly understood, it is relatively straightforward to adjust the financial data into a form that provides a reliable basis for financial analysis and prevents misleading conclusions.

Even some degree of caution can protect an organisation from relying on misleading data when making important business decisions. This illustrates the crucial role of risk management through robust control of financial processes and the support of accounting experts. Therefore, all organisations wishing to ensure that their accounting procedures provide reliable and accurate information should consider not only internal audit services but also ad hoc consultations with a statutory auditor, which will help identify areas in the organisation's accounting records requiring special attention.

¹  Pabianiak, P. Analiza Finansowa. Available at: http://www.analizafinansowa.org/analiza-finansowa/analiza-pojecia-podstawowe/50-zmiana-stanu-1.html

² Ibidem

³ Wpływ zmiany stanu produktów na przychody i koszty uzyskania przychodów. Biuletyn Informacyjny dla Służb Ekonomiczno-Finansowych, no. 28, 1 Oct. 2013