LIFO Liquidation and a Declining LIFO Reserve

A declining LIFO reserve can indicate inventory liquidation or falling prices.  If LIFO reserve declines in a rising price environment, then the analyst might become suspicious that current profit margins are over-stated because older goods are being sold and not replaced.  Replacing these goods at current cost might be higher than COGS is indicating.

The company, for whatever reason, may have stopped purchasing new, more expensive products, and in anticipation of a business slowdown and has begun selling off older inventory.

LIFO Inventory Liquidation in a Falling Price Environment

LIFO will show higher profit in a falling price environment.  If prices continue falling (possibly due to business cycle changes), then a company may cease to purchase new inventory.  As a LIFO business depletes its recent low cost inventory in a deflationary climate, profit margins will later go through a period of contraction when the company begins to sell its older, higher cost inventory.