How to Value Inventory When Selling a Business?
How to value inventory when selling a business is a valid concern since there is more than one way to valuate inventory.3 min read
How to value inventory when selling a business is a valid concern since there is more than one way to valuate inventory. For example, inventory can be valued according to the wholesale price or the retail price. Which you use will depend on the circumstance. There may also be questions over how much inventory to include in the sale price of the business. The buyer may want to consider inventory separately from the business.
There is no one correct way to approach this. Each situation is unique, so it usually comes down to the seller and buyer reaching an agreement.
Do You Include Inventory in the Business Valuation?
On the one hand, it makes sense to include inventory as part of a business valuation. You need inventory to keep the business running profitably after you buy it. That inventory is what gives value to the business. The seller, however, might not want the inventory considered as part of the business valuation. The seller bought that inventory separately and might need it to pay off debt.
Retail businesses usually have their inventory priced separately. But there are important considerations:
- Is the inventory of salable quality?
- How much inventory is necessary to run the business after buying it?
- Must the buyer purchase obsolete inventory, and if so, at what price? The buyer will be less likely to buy inventory that will not turn a profit in a reasonable amount of time.
The nature of the business can affect the value of the inventory. Electronics stores constantly need to keep up with changing technology. Clothing stores change stock with the seasons and fashions. In both these cases, old stock is of little value because it is hard to sell. Some businesses have inventory that defies technological innovation and fashions. Their stock will hold its value for years.
For the buyer, the decision to include or not include inventory in the business valuation must keep in mind a single truth: the amount you pay for the business must allow you to service debts, give yourself a salary, and keep growing the business.
How Much Inventory?
Before closing the sale, the buyer and the seller need to come to an agreement on how much inventory to include.
If there is more than enough inventory to keep the business running, the buyer can:
- Sell the inventory at discount and offer the seller a percentage of the wholesale price
- Pay the seller for the inventory as it sells
- Have the seller finance the inventory on terms commensurate with expected sales
- Allow the seller to keep all excess inventory
If inventory is a stumbling block to the sale, consider the quality and content of the inventory.
- What has the inventory turnover ratio been like over the past few years? How does it compare to the rest of the industry?
- Has the inventory been appropriately balanced and funded according to sales and inventory classifications?
- Does the inventory contain items that are seasonal, damaged, old, or obsolete? Consider removing them.
- Does the current inventory reflect the direction you intend to take the business? If not, do not include it.
The buyer's accountant will want an exact count of the inventory. Both the buyer and seller will also need a physical inventory count to determine the fair market value of the inventory. This should be done prior to closing.
There is no substitute for physically counting the inventory. Stock control software can be useful and give accurate results. However, it cannot account for:
- Data entry errors
- Software problems
This is how a computer may report something as being in stock when it is not. Only a physical count can verify the computer's information.
The buyer and the seller should both perform their own physical count a few weeks prior to the close of escrow. This will give them both a sense of the quality of the inventory and help them determine what to consider salable merchandise.
They should then hire an independent inventory service company to conduct the final count. This is an additional expense, but it will provide a detailed and precise cost value of the inventory.
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