Valuing Your Inventory in a Business Sale – Part 1 of 2

March 24, 2016

For industries such as retail, distribution, and manufacturing, disagreements over the value of inventory can kill deals. It is basically a non-issue in the valuation process when it comes to industries with little or no inventory like service, professional, IT, etc.

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.

Voilà – you now have the approximate value of the retail or distribution business. However, a prospective buyer may look 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, a 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 plans to sell your retail or distribution business in the near future, it would behoove you to critically assess the value of your inventory and take appropriate operational and accounting measures, so that when prospective buyers take a deep dive into the composition and valuation of your inventory during due diligence that 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 be 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.

Through the Michigan Chamber’s partnership with Praxis, we can guide you through a step-by-step process of the complexities, all while maintaining complete confidentiality. To learn more about selling your business, please contact Lindsay Fulton at lfulton@michamber.com or 517-371-7691.