Tuesday, 14 June 2011
Inventory is not included in business value
Pity the Accountant (or Business Broker) that has to explain to a business owner the following concept: The amount of inventory and equipment they carry typically has no direct impact on the value of their business.
Inventory is a tangible asset required to generate sales and earnings. What is important is the amount of cash flow generated from these and other operating assets, not the value of their assets.
In purchasing businesses, buyers don’t determine the value without its equipment or without its people and then through some mysterious process add the value of these items later. Many business owners believe their business has a value without the inventory and equipment and buyers will pay extra for whatever inventory and equipment is on hand.
The correct way to look at it is to consider the following examples of two businesses. One business was a trucking company that had $500,000 in trucks and dispatch equipment that was required to operate the business. The other was a roofing company with a small amount of employees and only $45,000 in inventory and equipment. The trucking company generated $200,000 in cash flow and the roofing business earned $800,000. Even though the trucking company had more hard assets, most buyers would find the roofing business a much more attractive company because of its significantly stronger cash flow.
Proponents of the “add-on” inventory philosophy would lead us to believed that if the above two businesses each had a cash flow of $300,000; the trucking company would justify a higher price. This does not make good business sense. Why would someone pay more for the same level of earnings? Knowledgeable buyers are interested in a business’ cash flow and insist the assets needed to generate it are included in the sale price.
Use of the “add-on” inventory method is rationalized by business owners based on the concept that inventory will fluctuate throughout the year. Unfortunately, this method increases the risk for any given business as the inventory at closing may not be enough to support the cash flow, thus requiring the buyer to invest within to support the business. At best, adding inventory to the price of a business increases the risk that the buyer will not get their expected rate of return on their investment. At worst, this method could lead to business failure because of being undercapitalized and unable to acquire additional funds to get the necessary inventory.
The fact is that many businesses do not have significant variations in the amount of inventory that they carry throughout the year. For those businesses that do, they tend to do so only during a few months of the year, such as holiday seasons. It is not that difficult to determine the inventory that should be included in the price to support the annual gross sales and cash flow. By doing so, the buyer can prepare for the needed investment by arranging for the required working capital in their equity or debt capital structure.
Assets and inventory are considered when a business is being sold under less-than-ideal conditions, such as when the company has not profits or cash flow. In those cases assets such as inventory and equipment would be used to determine the value of the business. Problems then arise in establishing the worth of those items. Typically, buyers usually aren’t interested in these businesses because the seller already has proven that the company hasn’t made a profit.
Do you have small business questions you would like answered about this article or others? Please visit www.VRWindsor.com or call 519-903-7807.
William Sivell is a sales representative of VR Windsor Inc., Business Brokerage; his blog appears every Tuesday.