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Enhancing Value: Monitoring Inventory Turns

Posted by David Humphrey on 30 April 2015 | Comments

A review of Inventory Turns is often an important part of a buyer’s analysis.    Since many businesses have a significant amount of capital tied up in inventory, how fast, or how many times per year a business turns inventory can be as important as the gross margins the business achieves.  If there is a significant difference between a subject company and their industry or businesses of similar size, the owner needs to be able to explain to buyers the reasons for this difference. The owner must demonstrate that their model is efficient, profitable and serves a purpose, thus should continue.

Business A sells products at 20% margins, thus when they sell a million dollars of product, they net $200,000 after cost of product.

Business B sells the same product at 30% margins, primarily to people who did not comparison shop, where convenience was a factor (someone could stop by and pick it up), or when Company A was out of stock and B was the only one with product on hand.  Either way, Company B only needed to sell $667,000 of product, one third less than Company A, to make the same $200,000 in margin. 

Thus, so long as Company B sells 2/3 of the industry average or more, with the same level of operating expense as Company A, the owners of Company B work less and has fewer dollars tied up in inventory and receivables. 

However, if Company B is not able to sell the right level of product, the owner will likely lose customers and market share over time, resulting in lost profits and decreasing market value of the business each year.

A few years ago we worked with a business that sold airplane parts. Companies in the industry tended to sell their parts at 30% margins and turned inventory 6 times a year.  Our client was sold parts for older aircraft.  If you had an older plane (think World War II era) and needed a part, he was one of only a handful of places in the country that carried them.  Most of his parts were acquired after salvaging them from old aircraft or buying out the dead stock of a traditional warehouse for pennies.  He turned inventory slowly as he sold parts he may have had in stock for years. Thus while his inventory turns were below average, he made up for it with higher margins.   Even after deducting the labor costs to salvage the parts, writing off scrap inventory and the time value of money for holding the inventory so long, he still realized a higher margin and was a more profitable business than the industry average.

Knowing where your business fits in the business model, especially with regard to capital intensive inventory and how your business compares to your industry is an important negotiating point.  Remember the buyer will likely have this information