The whole issue of inventory can become quite convoluted when buying and valuing a business because there is no set standard for how it is treated and there are many schools of thought on this component of a valuation.
Personally, I am a proponent of valuing a business based upon a multiple of the historical and provable Owner Benefits. I simply believe that profit is the only way to pay the bills and is the only tangible entity that a buyer will ultimately extract from a business. Hard assets like machinery and equipment are simply a means to generate revenues and so they play a far lesser role in the actual valuation in my opinion.
Inventory however, is not so clear. When you are buying a going concern, you have to start off with an optimal level of inventory to sustain the sales and profits upon which you value the business. As such, the argument can easily be made that including inventory as part of a seller's cash flow valuation makes perfect sense.
Yet, a seller can rationalize that it has to be treated independently because they have already paid for it, or, they may have to retire debt related to it, and so the buyer needs to purchase it separately.
Additionally, the actual type of business should dictate how the valuation is structured. Typically, retail businesses will be priced with the inventory being treated separately. But, there are a few things to consider:
What about cases where the inventory does not reflect an optimal level? It is common to see jewelry businesses as example where the value of the inventory if purchased at wholesale cost could render the whole deal ineffective. For example, there was a jewelry store for sale recently with $75,000 of Owner Benefits, $400,000 in Revenue but $550,000 of inventory at wholesale. The seller expected a multiple of the $75k plus full value on the inventory. The buyer calculated they would have to work seven years just to recoup their investment, IF, everything sold in a reasonable time period.
Similarly, a recent listing of an Internet business had $100,000 of inventory but unfortunately, of the $100,000 only $15,000 was regularly selling product. The buyer would either be stuck with merchandise for years or would incur a loss to liquidate it.
In cases where the inventory levels are not commensurate with the ongoing operations of the business at the existing levels, you can:
Regardless of how the inventory is treated, there is one absolute that buyers cannot sway from and that is the complete valuation picture. In other words, whether inventory is treated separately, or incorporated into the entire price (meaning you offer a certain amount for the business including inventory), the total price must fit within acceptable boundaries that will allow you to service any debt, pay yourself a salary and grow the business. No matter how you allocate the price, it has to make economical sense for you and no argument in the world from a seller can hold water if, at the end of the day, you cannot accomplish these three key fundamentals.
If you want to learn more about business valuations, we have just uploaded a sixty minute audio file that you will find to be very helpful. Here's the link to the page where you can listen to the Valuing A Business segement or the additional recordings on Due Diligence and Choosing The Right Business.
Have a great week.
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