How to Handle Inventory When Valuing a Business: A Simple Guide

How to Handle Inventory When Valuing a Business: A Simple Guide

We’re a seasoned business valuation firm, deeply entrenched in the world of acquisitions. A large segment of the businesses we value is headed for acquisitions, often by utilizing SBA financing. Over the course of our work, we’ve pinpointed a persistent issue: the nuanced treatment of inventory during valuation.

Why Is This on Our Radar?

Here’s the deal: Many businesses are valued based on a multiple of earnings. That’s Business Valuation 101. But here’s where things get tricky. When the business is listed or when drafting purchase agreements, there’s often a clause to slap the inventory’s value on top. It’s a little like being handed a bill at a restaurant and then being told, “Oh, by the way, drinks are extra.”

Let’s dive deeper into this.

Why Inventory Matters

Inventory is the lifeblood of many businesses, especially if you’re in the retail or wholesale sphere. It’s like the secret sauce that keeps things spicy. But the real question is: how spicy, or valuable, is that inventory?

It’s Not Just About Quantity: Sure, having tons of products stacked up might look impressive. But are they all saleable? No one wants that stock from three Christmas seasons ago!

Valuation Methods Vary: Did you know inventory can be valued in several ways? FIFO, LIFO, and weighted average cost are just some of the methods out there.

The Big Debate: To Add or Not to Add Inventory to the Purchase Price

Here’s where things get interesting:

The “Add-On” Camp: Some believe in adding the inventory value on top of the business’s value. The thinking? You’re buying more than the company’s future earnings. You’re also getting all those tangible goodies—the inventory.

Double Counting Alert: However, if the value of the inventory is already wrapped up in the business valuation, adding it again is, well, like counting your cupcakes twice. And while we all love cupcakes, no one likes overpaying! When evaluating a business based on its earning potential (often using methods like EBITDA, SDE multiples or discounted cash flow), the future revenue streams of the business are central to the valuation. Here’s a step-by-step breakdown of this perspective:

  • Revenue Recognition: Businesses, especially in the retail and wholesale sectors, generate revenue by selling their inventory. When valuing based on future earnings, you’re inherently considering the sales of the current inventory.
  • Costs Included: The cost associated with the inventory (such as procurement or production costs) has already impacted the profit margins and, therefore, the valuation. By this logic, the inventory’s cost side has also been factored into the business’s value.
  • Cash Flow Projections: If the valuation employs discounted cash flow (DCF) methodologies, it’s estimating the present value of future cash flows the business is expected to generate. Since these cash flows arise from the sale of goods (i.e., the inventory), you’re essentially accounting for the inventory’s value in terms of its contribution to future revenues and profits.
  • Double-Counting Risk: Adding the value of the inventory on top of a valuation based on earnings can be seen as double-counting. Why? Because the earning potential already assumes the sale of that inventory. If you’re paying for future profits and then separately paying for the inventory that generates those profits, it’s like paying for the same thing twice.
  • Market Comparisons: When comparing businesses, if one company has its inventory value baked into its price and another doesn’t, it might skew comparisons, making one seem more valuable than the other unfairly.

Smart Compromises

Valuation Minus Inventory: One savvy approach? Value the business without the inventory. This is a little bit trickier because we need to back out normal working capital/inventory from the enterprise value. Then that would be your base value then you can add inventory on top. 

Standard Levels: Alternatively, seal the deal for a price that includes a “normal” inventory level. Anything extra? That’ll be an added cost. This is my personal favorite. You determine what is “normal” inventory and this should be included in the purchase price. Anything over that amount is added to the purchase price, and vice versa. 

Why Give Some Inventory the Side-Eye

It’s simple. Buyers want value for money. If a chunk of that inventory is as sellable as last season’s mulled wine after Christmas, they’d understandably be wary of paying top dollar. Here’s a more in-depth exploration of why some buyers and valuation experts might do so:

  • Obsolete Inventory:
    • What It Is: Inventory that is no longer sellable or has diminished in value because it’s outdated, out of style, or perhaps even expired.
    • Why It’s a Concern: It ties up capital and takes up storage space. If a significant portion of a business’s inventory is obsolete, the business might not be as valuable as it appears at first glance.
  • Slow-Moving Inventory:
    • What It Is: Inventory that doesn’t sell quickly or turns over less frequently than other items.
    • Why It’s a Concern: Slow-moving items can indicate a mismatch between the products a business offers and what customers are seeking. This could imply a deeper issue with product selection, marketing, or market fit.
  • High Holding Costs:
    • What It Is: Costs associated with storing inventory for prolonged periods, including warehouse rent, utilities, insurance, and potential spoilage.
    • Why It’s a Concern: High holding costs erode profit margins. If a business is holding onto inventory for too long, these costs can significantly affect its profitability.
  • Lack of Proper Inventory Management:
    • What It Is: Inefficient tracking, reordering, or management of stock levels.
    • Why It’s a Concern: Poor inventory management can lead to stockouts (missing sales opportunities) or overstock (wasted money on excess inventory). It can also signal broader operational inefficiencies.
  • Inaccurate Valuation Methodology:
    • What It Is: Using an inappropriate method to determine inventory value, such as valuing old inventory at its original purchase price without accounting for potential depreciation.
    • Why It’s a Concern: It can inflate the perceived value of the inventory, misleading potential buyers about the actual worth of the stock.
  • Economic and Market Shifts:
    • What It Is: Changes in the broader economy or industry-specific trends that impact the desirability or value of certain inventory.
    • Why It’s a Concern: For instance, during a sudden economic downturn, luxury items might become harder to sell. If a business holds significant stock in such items, its inventory’s value could be overestimated.

Final Thoughts

Remember, when it comes to valuing a business, inventory is just one piece of the jigsaw. It’s essential, but how it fits into the bigger picture depends on the agreement between buyer and seller. When valuing a business or considering a purchase, it’s crucial to examine the inventory closely. It’s not just about quantity; the quality, relevance, and sellability of that inventory play a significant role in the actual value it brings to the table. Thus, giving inventory the proverbial “side-eye” can be a crucial step in ensuring a fair and accurate business valuation. Reach out to our seasoned team at BGH Valuation. With a wealth of experience and a sharp eye for detail, we’re here to ensure you get the clarity and guidance you need.

Let’s talk about business value. Contact us today!
Brandon Hall