Not every businesses is reliant on stocking inventory. For the businesses who actually do rely on inventory, they recognize it can represent one of the most significant assets within the business, apart from the human capital running the operation. Standard stocked inventory is often included in the purchase price of a selling enterprise. Such inventories are helpful in generating regular profits for the company and its shareholders. In some cases, inventories can represent a large asset, much like machinery, because it helps produce the cash flow necessary for the company’s survival. Because a business purchase would either mean a replenishment of under-stocked inventory or a purchase of previously-held inventory, the valuation of a business often hinges greatly on the amount of inventory on hand. There are a number of key factors important to how the inventory can effect the valuation and what to do about it in M&A deals. Here are some 30,000 foot insights.
- Inventory Auditing. Prior to a sale and as part of the overall due-diligence checklist, a physical inventory count must occur. After this is done inventory is adjusted either up or down based on the findings of the audit. This is reflected in the valuation and ultimately the sale price of the company. In the case of seller financing, principal due may decrease on the held note rather than the cash due at the time of deal closure.
- Valuation at Cost. In some cases inventory levels may be significantly higher than normal. If the buyer is required to buy above the “normal” level of inventory, what will the extra cost be and how will it effect cash flows going forward. Is such extra inventory marked according to FMV? Will any of it need “written down” at the end of the period?
- Inventory Valuation. Valuation of inventory can be open to speculation. Will the parties agree to original invoice amount, a percentage of the current retail price or will a third-party inventory valuation firm be utilized to determine the price of the inventory?
- Variability of Inventory. Not all inventory is created equal. Age, obsolescence and/or damage will bear on what the true value of any held inventory will be. Each will be an option on the chopping block when the deal goes to M&A negotiations.
- Valuation of Manufacturing Inventory. For a business with raw materials, work in process and finished goods valuations models can be much more complex and often require a more seasoned inventory valuation.
- Raw Materials. Raw materials includes anything not already in the production process. It’s pretty self explanatory and a bit easier to value on a per-unit basis as it is generally based on the worth of the item at the time of sale.
- Work in Process. Work in process includes any inventory which is somewhere along the value process of being developed into final or finished goods. The cost of work in process or WIP, as it is often called, includes depreciation on equipment, cost of labor and other manufacturing overhead costs.
- Finished Goods. The cost of finished goods includes labor, manufacturing overhead and raw materials for the final product. It is what is eventually shipped to customers. If the business is unable to understand the cost of finished goods, they’ll not be able to fully make margins sufficient to keep a sustainable business.
Understanding and know the costs involved in inventory valuation through due diligence will help business investors more fully understand the business, its costs, the overall competitive environment and the potential profit drivers and maximization opportunities for the company. Failing to understand inventory hurdles, strengths and opportunities when it comes time to sell or buy a business
can mean the difference in making a positive ROI. Don’t let the seeming simplicity of inventory fool you.
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC, a middle-marketing M&A and capital advisory firm. Nate works with corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He holds Series 79, 82 & 63 FINRA licenses and has facilitated numerous successful engagements across various verticals. Four Points Capital Partners, LLC a member of FINRA and SIPC. Nate resides in Seattle, Washington. Check the background of this Broker-Dealer and its registered investment professionals on FINRA's BrokerCheck
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