Preparing for Inventory Due Diligence
From the BCC "Baton" - Volume 14, Issue 2
For many companies, inventory represents a large portion of current assets. Whether it is a distribution company required to keep products in stock to fulfill customer orders or a manufacturer with raw materials and work in process, inventory can require a significant investment and affect working capital calculations in an ownership transition. For this reason, acquirers will spend a good amount of time performing due diligence on inventory. What types of analysis can a seller expect a buyer to perform, and what can a seller do to be prepared for the process?
There are several key issues that a buyer will want to understand when it comes to evaluating a seller’s inventory:
- Valuation Method – Due to the change in the cost of acquiring inventory over time, the method used to value inventory will produce different results for ending inventory and cost of goods sold. During inflationary periods, the first-in, first-out (FIFO) method understates cost of goods sold as it is based on inventory bought at lower prices resulting in an overstatement of net income. However, it also gives a more accurate value for ending inventory since it is based on more recent inventory prices. The opposite is true for last-in, first-out (LIFO) which is less commonly used. Using LIFO requires a LIFO reserve to be recorded on the balance sheet representing the difference in inventory costs between the two since the date LIFO was adopted. Another method commonly used is average cost, which utilizes a weighted average of inventory units to determine cost of goods sold and ending inventory. A buyer will review the method used when valuing the business and calculating working capital.
- Inventory Quality – Sellers can expect a buyer to analyze how long inventory has been on hand and whether there is still demand for the product. Products that are deemed obsolete or slow-moving are generally excluded from a sale and the calculation of working capital. A significant amount of unwanted inventory is likely to reduce the value of a business substantially.
- Physical Inventory – Typically, a buyer will perform its own physical inventory or engage a third party to audit the seller’s inventory. This involves an on-site review to ensure reported inventory matches actual inventory, both in quantity and quality (not damaged, altered, etc.).
How to Prepare
It is important to not be caught off guard during the sale process. Taking steps to evaluate inventory ahead of a sale can uncover items that need to be addressed before they cause issues further into the sale process. Consider the following actions:
- Perform a physical inventory count yourself if you do not already perform one regularly.
- Contemplate selling or scrapping slow-moving or obsolete inventory.
- Review internal accounting procedures to ensure accurate inventory recordkeeping.
- Be prepared for an in-depth review of inventory by a third party.