Acquiring another business or portfolio company can be an onerous process, especially if that company has never been audited before and has not historically maximized shareholder returns or provided detailed reporting to a board of directors. Adding complexity to the process, U.S. Generally Accepted Accounting Principles (GAAP) require assets, liabilities and equity acquired during a business combination to be valued at fair value at the date of the acquisition.
Determining fair value is a relatively straight forward process for certain assets. However, it’s a different story when it comes to inventory and should be examined closely prior to, and well in advance of, your purchase.
How is Valuing Inventory Different from Valuing Fixed Assets or Receivables?
Often, companies making an acquisition hire a third party to value fixed assets, such as land, buildings, equipment or intangibles, but leave other assets and liabilities on the balance sheet as their carrying value, also known as net book value. While leaving items on the balance sheet at their carrying value is fine for accounts receivable or accruals, both of which are expected to be converted to cash at the amount stated on the balance sheet, inventory requires a more advanced valuation process.
The fair value of inventory is generally measured as net realizable value, or the selling price of the inventory less costs of disposal and a reasonable profit allowance for the selling effort. The basic premise of GAAP is that inventory should not have built-in gains upon purchase date that will be recognized in the income statement as gross profit of the inventory, as it is sold subsequent to the purchase of the company.
>> Read “M&A Essentials: Elements of Value — Enhancers and Detractors”
Since a company adds little value to raw materials or component materials, the price a market participant would pay and is generally considered fair value. Companies do, however, add value to finished goods and work-in-process inventory, so those items will require a calculation to determine fair value. Below are three steps to assist you in estimating that value.
1. Calculating the Selling Price of Your Inventory
This should be a fairly simple exercise, in that the selling price of your inventory is either the retail price customers would pay or the price retailers would pay in a wholesale market. Based on this, most purchasers can produce a sales-by-item report, which can be easily cross referenced against the detailed inventory listing to provide a gross inventory fair value before the adjustments described below.
2. Calculating the Disposal Cost of Your Inventory
The disposal cost of your inventory is generally considered the cost to get the inventory to the condition and/or location so it can be sold. In the case of finished goods, this may just be the freight costs to deliver the items; you could estimate the cost to complete the sale for finished goods based on the company’s overall freight-out costs as a percentage of total sales. In the case of work-in-process inventory, you would need to calculate the cost of labor and overhead required to complete the inventory, and then deduct that amount off the calculated selling price as determined above.
3. Calculating the Selling Costs of Your Inventory
Selling costs refer to the costs of selling the inventory. This is the most subjective area of the calculation and can include a broad array of costs. That being said, stick to a reasonable and justifiable approach. Include only those amounts directly related to the selling effort, such as sales commissions, postage, shipping supplies and trade show expenses. These items may represent a reasonable profit allowance.
>> Listen to our podcast: “Why You Should Have Your Business Valued — Even When You Don’t Have to”
Based on the complexity of the calculation above and depending on the technical expertise of your company’s personnel as well as the sophistication of your enterprise resource planning (ERP) system, buyers may want to consider hiring an independent valuation specialist to help determine the fair value of inventory well in advance of the deal close. This also may help identify any other unknown inventory issues. Similarly, getting your auditor involved before the deal closes assists in limiting subsequent issues and streamlines the audit procedures. Additionally, you may be able to include opening balance sheet procedure costs as part of the deal costs and exclude then from the subsequent bank covenant calculations, as they will be paid at close.
Contact Russ Burgett at rburgett@cohencpa.com or a member of your service team to discuss this topic further.
