Valuing Inventory in Business Transactions – Part II

Last month we addressed the role inventory plays in the value of service, professional, IT, retail, and distribution businesses. The issue of manufacturing inventory is generally far more complex than these other industries, and as such has earned an entire monthly blog.

When we meet prospective sellers of manufacturing businesses, we hope that (a) the inventory is valued according to GAAP (generally accepted accounting principles), and (b) has a turnover rate matching industry standards (usually at least 6x annually). When we find both (a) and (b) in good shape, there are no inventory issues. The inventory is usually included in the sale and becomes part of the purchase price which will be a multiple of cash flow (as defined). Perfect.

When either (a) or (b) doesn’t pass muster, we can accurately forecast a problem with the valuation as well as with potential buyers. When both (a) and (b) don’t cut it, there are problems which can be as serious as our informing the business owner that he has an unsalable business.

The goal of an owner of a manufacturing entity should be to have his inventory valued on a cost basis with a standard labor rate which reflects what the work force actually gets paid. Then overhead should be added again at a standard rate which reflects what the shop overhead is. Often, we see overhead rates which include not only shop costs, but general and administrative costs which results in an inflated overhead rate and therefore an overstated inventory. The flip side of an overstated inventory is unfortunately overstated profits. So, an inventory which let’s say is overstated by $100,000 reflects a $100,000 overstatement of profits. If the business in this example has been valued at 5x profits, the business valuation has shrunk by $500,000 – not a happy event for the seller.

It can get worse if the inventory is excessive; i.e. does not turn at (or close to) industry standards. If a business has an inventory that is turning at 3.5x annually vs. an industry standard of 7.0x, a prospective buyer will be reluctant to pay for all that inventory knowing that his competitors will have much less capital tied up in inventory. That means he will be at a competitive disadvantage from day one.

We have had sellers say “what’s the problem? – we will just give our customers a great deal to load up on product before the closing thereby driving down our on-hand inventory.” Bad idea. Every business sale has deal documents which specify business as usual from the letter of intent through closing. Blowing out inventory is not business as usual.

Assuming the inventory, while excessive, has an appropriate GAAP valuation, then negotiations will commence on (a) how the purchase price multiple should be adjusted downward to compensate for the excess inventory, and/or (b) how the terms of the sale might be modified in the buyer’s favor, which can be as harsh as consigning (vs. having the buyer purchasing) some of the inventory at closing.

Issues with inventory values and amounts as outlined above at best can be costly to the seller and at worst will make his business unsalable. So if a business sale is on your horizon, we strongly suggest aggressively assessing all facets of your inventory to make sure that after the pre-closing physical inventory, the buyer of your business pats you on the back and says “good job on managing and accounting for your inventory.” If you sense you have a problem with your inventory, please discuss your concerns with your CPA or business advisor with the goal of getting on a corrective path ASAP. You will be glad you took a proactive approach.

Contributed by Michael Greengard, Praxis Business Brokers.