Business Buyers Will Always Check For This… It Could Be Costly
Blog Series 6 of 6
Author: Mark Mroczkowski
Acquisition transactions that are the most challenging tend to involve companies where the inventory was either under-managed or used aggressive inventory tax strategies. Many variables affect the valuation of a business and the terms of a transaction; however, for product-oriented companies (such as manufacturing and distribution businesses), inventory valuation is probably the most overlooked economic consideration before executing a letter of intent. During diligence, inventory quality and accuracy can significantly affect the EBITDA, purchase price, working capital settlement, and even the buyer’s debt structure and capacity at closing.
In simplistic terms, inventory is not just a balance sheet account but a significant component of a company’s cost of goods sold, which largely determines business earnings. The methods that management uses to manage inventory and determine its cost can either understate or overstate its earnings and EBITDA. Inventory valuation also affects the balance sheet either positively or negatively, which significantly affects its borrowing capacity. It is a good practice for business owners and their advisors to undertake the following before marketing a company for sale:
- Perform a complete physical inventory two months in a row.
- Perform a complete inventory aging analysis and inventory turnover rate.
- Update inventory reserves.
- Update the company’s cost roll and capitalized labor allocation to finished goods.
- Update the company’s inventory valuation and earnings based on raw materials’ market cost and purchased items.
Acquisition transactions are time-consuming, stressful, and costly. It is better to address the valuation of inventory and its components before beginning a sale process to avoid what could be a deal-killing problem.