By: Jeffrey D. Jones, ASA, CBA, CBI
Inventory is a tangible operating asset of a business just like the other operating assets needed to generate revenues and earnings. Some businesses are equipment heavy and others are people heavy. In valuing a business, we don’t determine their value without the equipment or without the people and then somehow add the value of these items to the price of the business. Yet, some business owners expect a buyer to pay a value for their business without the inventory, and then add whatever inventory is on hand at closing as an additional cost.
The fair market value of any businesses is based on the concept of providing the owner with economic benefits. First, there should be sufficient earnings to pay the owner a reasonable salary. Next, the earnings should be sufficient to provide a reasonable return on all the tangible assets, including inventory, necessary to operate the business. Any remaining earnings are a result of the intangible assets, such as goodwill. It is impossible to accurately determine the value of a business without knowing the full extent of the required investment needed to produce the expected level of earnings.
Use of the “add on” inventory method is justified by business owners and some business brokers based on the concept that inventory will often fluctuate throughout the year, so rather than try to determine the amount of inventory needed to support the reported revenue and earnings, they add it based on whatever it is at time of closing. This method greatly increases the risk that for any given business, the inventory at closing may not be the normalized amount needed to support the revenue and earnings, thus requiring the buyer to pony up additional funds within a few days or months to adequately support the business. At best, blindly adding inventory to some predetermined price increases the risk that buyers will not get their expected rate of return on their investment. At worst, this method may well lead to business failure due to being undercapitalized and unable to obtain additional funds needed to acquire the proper amount of inventory.
The “add on” inventory mentality would have us believe that two businesses, each with discretionary earnings of $100,000, should be priced the same, except that businesses with inventory should be worth more due to the inventory. This is simply not correct and does not make economic sense. Why would someone pay more for the same level of earnings? Prudent buyers want all the assets needed to generate the expected level of earnings included in the price.
Many businesses with inventory do not experience great variations in the amount on hand throughout the year. Those businesses that do experience significant swings in inventory levels tend to do so only during a few months of the year, such as holiday seasons. It is not that difficult to properly determine the amount of inventory that is needed to support the annual gross revenue and earnings. Then at closing, the sales price can be adjusted up or down from the normalized inventory level based on the amount of inventory then on hand.
There are several methods business brokers and appraisers use to analyze inventory and estimate the normalized value of inventory to be included in the price of the business. These methods include:
Average Daily Inventory – This method divides Cost of Sales for the year by 360 days which represents the average daily inventory amount that is sold. Then an estimated inventory needed on hand can be determined by multiplying the average daily inventory by the average number of days needed to secure inventory.
Average of Beginning and Ending Inventory – Add the inventory on hand at the beginning of the year to the ending inventory at the end of the year and then divide by two. These amounts will be shown on the balance sheets of the company’s tax returns and financial statements. This method works well if there are no major swings in inventory levels throughout the year and inventory can be purchased with minimum lead time.
Average 12 Month Ending Inventory – Another method of determining normalized levels of inventory is to review the 12 months of financial statements for a representative year and then add the ending inventory from each statement and divide by 12. This method works best when the company does an actual monthly inventory or has a perpetual inventory system and inventory can be purchased with minimum lead time. In the event purchase and delivery lead time requires inventory levels to be greater than one month, then the average monthly inventory will need to be adjusted for the number of weeks or months needed to support the lead time.
Weight Average Monthly Inventory – The concept of this method is to weight each month’s inventory based on its proportion to total inventory. This method works well when monthly inventory significantly varies throughout the year.
Industry Ratios – Use of Industry Ratios is yet another way of determining normalized inventory. RMA’s financial ratios report inventory turnover ratios for most industries. This ratio can be utilized by dividing Cost of Sales by the Inventory Turnover Ratio.
No one wants surprises at closing due to miscalculation of the inventory amount needed to operate the business. The above methods of determining the normalized amount of inventory to be included in the price of a business can be effectively used in conjunction with an analysis of the company’s financial statements, consultation with the owners, and input from their financial advisors. Additional adjustments to the inventory may be needed to account for damaged, non-salable, outdated, or excess inventory.
Jeff Jones is President of Advanced Business Brokers, Inc. and Certified Appraisers, Inc. 10500 Northwest Frwy., Suite 200, Houston, TX 77092. www.advancedbb.com., jdj@advancedbb.com.
