Author was a financial executive and corporate auditor for General Electric Company (GE) over an 18-year period and CFO of an American Stock Exchange company as well as other “C” Level financial assignments. He has acquired businesses from seven dollars for a $250 million dollar revenue business to a $2.3 billion acquisition for GE in 1988
Inventory in Business Brokerage. Some thoughts.
Over a thirty plus year corporate career and over ten years as a Business Broker / M&A Advisor, I have found many areas of inventory accounting that could be of interest to the business broker who wants to maximize the price for a Seller.
I generally have found that general practitioner CPAs (as compared with specialist CPAs) do not account for Inventory correctly in companies because business management focuses on the minimization of tax liability.
Manufacturing entities have inventory of various kinds and Business Brokers should at least know what each category is and how the accounting process should work. There are Raw Materials, Indirect Materials, Finished Goods, Direct Labor, Work-In-Progress (WIP), Indirect Labor, Direct Overhead, and Indirect Overhead components of Inventories. Business management of earnings by not accounting for inventory according to Generally Accepted Accounting Procedures manages the tax bill for the prior year’s results in a direct understatement of Seller’s Discretionary Earnings (SDE).
Construction Businesses generally have unfinished projects at the end of each year, why don’t they have WIP Inventory on the books at year-end? Answer, it reduces Taxable Income.
What should we do? First, anytime I discuss a business with a potential Seller, I tell them that we want to get their books stated correctly. This demonstrates the quality of their financial records to a potential buyer and increases the SDE thus the resultant price with whatever multiple is used for pricing. If I am fortunate enough to get someone who is planning on selling the business in the future, I tell them to record inventory correctly at the latest year-end if they have not filed their tax returns. What happens?
For example. a construction business who averaged $75,000 plus of WIP at each year-end. They let it be written off to Cost of Goods Sold which resulted in lower taxable profit and lower SDE. They had Revenues of $12 million plus a year and had taxable income of $650,000. The business grew a bit each year. It appeared that their business would have a 3.3X multiple of SDE from the comparable business sales with their niche, revenue growth, and served market. At a 3.3X their value would be over $2 million and if we could have the prior year-end “corrected” to reflect the correct WIP Inventory, we could have added $75,000 times 3.3X or $220,000 plus to the List Price. The financial Partner wanted to clean this up, the Operating Partner who was the seasoned veteran did not because that meant that in April, they would add $35,000 to their tax bill. He just couldn’t understand that paying $35,000 in additional taxes (a one-time event) for an additional pricing of $220,000 plus was a smart move.
Here is another example, many years ago I looked at a very interesting company that bought special kinds of engines and tore the engines down for certified parts reporting $350,000 of SDE a year with $400,000 of inventory. They had an appraiser come and do an appraisal of their inventory. The appraised cost value of their inventory at material cost only (I argue that the cost of people tearing down the machines and certifying the inventory should have been in inventory and not expenses) was $2.5 million as every year they wrote off all new acquired engines to Cost of Goods Sold. They were understating earnings by an average of $650,000 or more a year. How was the business priced? Two times SDE of $350,000 plus the $2.5 million of Inventory or $3.2million. They just couldn’t get anybody interested. What was the real value? If you had a business making a million dollars a year ($350 + $650) with $ 2.5 million of inventory, I would argue that they should have been listed for at least $4 million. So, playing games with the numbers over the years resulted in understating the value of the business and making the business unsaleable. (Note (1) when SDE can’t support Debt Service and (2) Inventory is far more than one year’s COGS, it makes a business very difficult to sell.)
Myt last example is what knowledge of Inventories can do to help maximize value in a normal situation. I marketed and sold a business for $2.5 million. They did not record Work-in -Progress inventories. I marketed the business for a multiple of Earnings plus WIP Inventory to be calculated at the date of sale. I worked with the Seller and Buyer to identify the Raw Material value as well as the Labor value tied up in WIP at the sale date. Including Labor added another $35,000 to the funds received by the Seller. If I did not understand that Labor should be a part of WIP and how to discuss this with a Buyer, my Seller could have lost this extra $35,000.
So, my argument is that having knowledge of Inventory Accounting and having Inventory properly stated at the last year-end and if possible, for the coming year’s Budget, can and should result in a higher selling price for your Sellers; thus, an increase in your commissions from successful business sales. The key is to have two to three years of quality/consistent financial information.
So, the numbers are clear, what else can there be? The second part for you to consider is that higher quality financial records support a quality price and sale of the business.
Remember that general practitioner CPAs have little understanding of detailed inventory accounting and generally operate according to common practice of the business owner. Operating Accountants and business analysts understand inventories and appreciate seeing a business with quality accounting standards and practices.
Think about these points the next time you look at a manufacturing or construction business!
Dale Shepherd Vice President
Managing Director TN, NC, VA
Master Certified Business Intermediary and Certified Franchise Broker
Capital Business Solutions, Kingsport, TN
