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Valuing Inventory in Business Transactions – Part I

How is inventory figured in the value of a business? For industries which have little or no inventory like service, professional, IT, etc., inventory is basically a non-issue in the valuation process. But for other industries such as retail, distribution and manufacturing, disagreements over the value of inventory can kill deals.

For retail and distribution businesses, the role inventory plays in the valuation process would seem to be pretty straightforward: the overall value of the business is the sum of a multiple of the earnings of the company and the cost basis of the inventory.

Voila – you now have the approximate value of the retail or distribution business – except bad things can happen when a prospective buyer looks more closely at the composition of the inventory during the due diligence process. Is the inventory stale? Is it excessive? Obsolete? Way too high in relation to sales (i.e. is the turnover rate too low in relation to sales or industry standards)? During a pre-close physical inventory will the final inventory figure come out too low or too high as compared to the book value of the inventory?

You get the idea. And to compound the inventory issue, any book to physical adjustment in the inventory will result in an increase or (more likely) a decrease in the historical profits of the business which in turns impacts the value of the non-inventory portion of the business. So what started out as a seemingly pretty simple matter of adding the value of the inventory to a multiple of earnings to determine an approximate business value has now turned into the proverbial can of worms.

If you have near term plans to sell your retail or distribution business, it would behoove you to critically assess the value of your inventory and take appropriate operational and accounting measures so that when during due diligence prospective buyers take a deep dive into the composition and valuation of your inventory they look you in the eye and say “good job on your inventory – we have no issues.” If you are not confident in your ability to address the inventory matter internally, CPA’s and business advisors can generally be quite helpful.

For businesses in the manufacturing sector, in which inventory is comprised of raw material, WIP (work-in-process) and finished goods, the issue of how inventory influences the deal price can be complex and sometimes contentious. The matter of inventory valuation in manufacturing businesses will be addressed in detail in next month’s blog.

Contributed by Michael Greengard, Praxis Business Brokers.