During a site visit to the business, the buyer says to the owner, “How much inventory is in this warehouse?”
“Oh, I don’t know, maybe $5,000,000,” says the owner.
“Is it all good?” says the buyer.
“I know that I will sell it all to someone, someday, we always have”.
“What about these items over here with the dust on them, are they still good?”
“Oh sure”, says the owner, “Someone is always stopping by looking for those. I think we are the only one in the area that carries them.”
The above is a typical conversation between a buyer and an owner. We have witnessed this exchange hundreds of times. However, it’s instructive to recognize what really happened here. The owner feels he just told the buyer clearly the inventory is all good marketable product, and that the buyer needs to purchase the entire inventory without exception.
What the buyer just heard was an owner demonstrate that he does not really know how much product in the warehouse, some of the product is slow moving but the owner is not sure how much is slow, that the owner is likely in denial about how much is really stale and certain items are so old other shops can’t make any money keeping them in stock. The discussion makes the buyer think the gross margins on the financial statements may be overstated because dead inventory is not being regularly written off in the normal course of business.
The buyer leaves this conversation with a distrust of the owner’s inventory control system generally, inventory valuation specifically and potentially his financial statements overall.
This is not a good situation for a business seller, and it is one that is completely in the owner’s control and simple to rectify.
First, owners should clean up their inventory on the financials. Inventory should be reviewed annually to identify product to be marked down or written off. These steps will result in more accurate financials and more trust from buyers.
When the buyer asks about inventory, the seller would have been better off with more details to provide the investor with better information demonstrating the owner has command of the business. Now compare this answer. “Inventory? I believe we just crossed the $5,000,000 level earlier this month, and will likely rise to a high of $5.3 to $5.4 in the next several weeks. Inventory is high this time of the year as we are heading into our busy season. However, the inventory will drop back to its more typical level of $3,500,000 once the bulk of the orders are shipped.”
A better answer to the slow moving inventory question might be something like, “We have two areas of the stockroom where we keep slower moving items. Over there are the items that are really old and have been written off. We keep them because we have the space and sometime they make us a hero to an overworked purchasing department. Over here are items that we keep on hand for a few key customers. They need these items several times a year and we are the only company locally that stocks them. We had to buy a lot to get the right price, but it keeps them happy and they do not go looking to others to fill their needs. They buy lots of product from us as a result”.
With these answers the buyer’s get a sense that the inventory is managed, and there is a reason for the items in stock far greater than a simple collection of miscellaneous parts.
One important aspect of a review level or audited financial statement is the verification of inventory and its value. For both a review and an audit, the accountant is present at year-end to verify the inventory count and also conducts tests to confirm pricing of the inventory using internal documents such as purchase orders or invoices. For businesses with significant inventory this can be a critical assurance to buyers analyzing financial statements. Outside verification of inventory is especially helpful since there is little that can be done in the present to verify the accuracy of inventory figures from prior years.