Over the past 25 years, Westshore’s principals have purchased many companies, but the transactions that are the most challenging tend to involve companies where the inventory was either under managed or reflected 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 prior to executing a letter of intent. During diligence, the quality and accuracy of inventory can have significant ramifications affecting 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 rather a component of a company’s cost of goods sold, which runs through the income statement and, hence, the earnings of a business. How a company has costed, managed, and represented its inventory can both understate and overstate the EBITDA of a business, as well as its balance sheet and its borrowing capacity. It is a good practice for business owners and their advisors to undertake the following prior to marketing a company for sale: 1) a full physical inventory two months in a row, 2) a complete inventory aging analysis, 3) an updating of inventory reserves, 4) an updating of the company’s cost roll and capitalized labor allocation to finished goods, and 5) an updating of the company’s inventory valuation and earnings based on market cost of raw materials and purchased items.
Transactions are time consuming, stressful and costly. Not addressing inventory and its components prior to a sale is a “game” that the buyer and seller will not enjoy.