How Inventory Impacts Business Valuation

– An Explanation of Excess Inventory –

Many business owners who are interested in selling their company often ask how the amount of their inventory impacts the value of their business.

Must business valuations for companies under $50M use market multiples of earnings [i.e. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) or ODCF (Owners Discretionary Cash Flow)] to determine value. Both these valuation methods assume a “normal inventory” level is provided at closing. Thus, only the amount of “excess inventory” can be added to the calculated value – not the total amount of inventory.

Reasons for Excess Inventory

Seasonality: A retail business might have higher-than-normal inventory near the beginning of the year-end holiday season, or some other high-sale period of the year.

Bulk Buying: Many business owners take advantage of discounts at various times of the year or discounts for buying large quantities, which will cause a higher-than-normal level of inventory.

Fear: Many organizations are excessively afraid of running out of inventory, so they end up with more than they really need.

Space: Excess inventory often accumulates when temporary warehouse space becomes permanent. This is a simple twist on Parkinson’s Law – Inventory increases proportionally to the amount of space provided for it.

How “Excess Inventory” is Calculated

One way to calculate excess inventory is to look at industry averages, more specifically inventory “turns” or inventory as a % of sales. Various databases can provide insight on what normal inventory is for many industries.

For excess inventory due to seasonality, you could obtain a month2month inventory count for a number of years, and take the average. Any amount “above the average” could be considered excess inventory and added to the calculated value.

If you’re interested in receiving a one-page PDF summary of all the steps in the 4 stages of selling a business, email Tom MacPherson and include “4 Stages of Selling a Business” in the Subject line.

The Summit Acquisitions Group — Business Brokers and M&A Advisors — specializes in the sale, appraisal, and financing of privately owned companies ranging in valuation from $500,000 to $5,000,000. Contact their offices in Atlanta, GA or Charlotte, NC for a free consultation.