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From KC Truby Lonesome Cowboy Publishing Inc. 301 Thelma Drive #426, Casper WY 82609 (760) 207-6385

Valuation When Inventory is Too High?

By on July 22, 2014

This is a thread from a group on LinkedIn that I belong to.  I found the information important enough to post here for you to read.  The group is ABBA and is a group of business brokers who share ideas and problems.  It is worth joining.

 

 

Tom MacPhersonPrincipal at Summit Acquisitions GroupTop Contributor

I have a seller client whose inventory is about 50% of sales [2 turns per year]. His inventory is imported, and it takes about 6 weeks to be mined, finished, and shipped to the US – and is paid for before shipping. While the asking price, based upon cash flow is fair ($900K price with $300K cash flow), his inventory is about $800K. That leaves only about $100K for the cash flow! (NOTE: A/R equals A/P, and there’s no other tangible assets to pass or liabilities to be assumed.) Is the business underpriced at $900K, or is the inventory too high due to poor ordering processes? Should we only include $500K to $600K of inventory in the sales price, and give the buyer the right to purchase the excess inventory as needed?

12 Responses posted here without edit….

Steve Brodhead

M&A Advisor to companies with $5-50MM revenue

Good solution proposed. It also seems as though the vendor should be willing to discuss flowing the shipments, and thus payment flow, rather than a few large shipments to assist with their cash flow–or finance some of the carrying cost. If they were sourcing locally, and on shorter lead times, what would be the desirable $ amount of inventory given that scenario? They might also look to include some amount of A/R (good and collectible; to be used as working capital) along with the inventory and which could be included in the financing package.

 

Tom MacPherson

Principal at Summit Acquisitions Group

Top Contributor

Thanks for your reply. Some more details and recent developments: 1) This is most a cash business, so collectible A/R is less than A/P – both of which I normally include in my deals. 2) Good question about “normal” inventory level. I believe the Seller maintains a very high level of inventory because he doesn’t want to lose a sale and because he has the cash. The problem arose when he received an offer slightly below his asking price and realized the inventory on his books (which was included in the price) did not include the substantial shipping costs involved – plus he had lots of inventory (paid for, but not on hand) on the high seas. 3) The seller has agreed to take the proposed offer (5% less than hoped for), but lowered the amount of inventory included with the price by the same amount. But, the buyer can obtain any of that inventory as needed for the price paid by the seller.

Harold C. Hillcher, MAEd

Expert Witness at Brokerage School, Inc.

Just something to think about. Is the book inventory at the same amount as the physical inventory. If the book is significantly less and the business is several years old you may be dealing with overstated COGS which means the business is actually more profitable than what the P&Ls or 1120’s may show. Sounds like a granite & marble importer/distributor. COGS is usually overstated to reduce income taxes and is counter balanced by a balance sheet adjustment for entry of the year end inventory number..

Tom MacPherson

Principal at Summit Acquisitions Group

Top Contributor

Harold: The Seller isn’t acting as if the Inventory is overstated on the books. It is a granite & marble importer/distributor. How’d you guess that? What is their normal inventory turnover – 4 to 6 times a year? This inventory is 1/2 annual sales. I’m a reformed accountant, but I don’t understand how one “overstates CoGS to reduce income taxes and ‘counter balance” by a balance sheet adjustment for the year end inventory number.” The internal financials match the tax returns for the past three years.

Harold C. Hillcher, MAEd

Expert Witness at Brokerage School, Inc.

Tom, I have been a licensee in Florida since 1970 and have specialized in commercial properties and business brokerage for over 30YRS. I have viewed thousands of 1120 returns and have valued many, many business including expert witness service to the courts. My experience is how I “guessed” the business. To answer your second question, they simply do not count the year end inventory correctly; therefore, purchases shown by check during the fiscal year account for a higher COGS because some of the inventory in that number is still in possession. This is not simply LIFO or FIFO it is know among us brokers as FISH. Try to figure that acronym out! If you don’t know it let me know and I will tell you the punch line. Is the physical inventory actually the same as the book? I would bet that he has four times or more value in the inventory on hand as apposed to the “book” inventory. Where are you located?

Jerry Myers, MBA, CBI

Co-Owner/Principal Broker at VR Business Sales

The IBBA Pricing Small Businesses course refers to the three methods of valuing inventory – LIFO, FIFO and WIFL. The latter standing for Whatever I Feel Like. I have a tombstone company here that would like to sell but they have so understated their ending inventory each year that they just can’t sell the business – the gain on the sale of the inventory would be very high, and they would have to, at sale time, repay all the taxes they saved over the years by understating ending inventory, and aren’t open to doing so. So, what is FISH, Harold?

Harold C. Hillcher, MAEd

Expert Witness at Brokerage School, Inc.

FISH “First In Still Here”

Don Rudnik

Sterling Commercial Credit

Sterling Commercial Credit is in middle of highly leveraged buyout buyout -less than 5per equity infusion. Inventory audit showed 1/4 of total hadn’t moved in two years. My recommendation is heavy analysis on any thing over six months and have a wrtten plan on selling for cash (or seller keeps) and adjusts the price. We may give value at 10percent to close deal but you can see how a buyer that hoped to get one past an eager buyer and a buyer eager needing the non bank lender to close If seller won’t adjust price or earn out the deal won’t close. Will know soon

 

 

Ryan Jorden

Managing Partner at VR Business Brokers | Mergers & Acquisitions

Whether or not they can increase their turns depends a lot on the seasonality of the business and their buying periods. I recently worked with a business that only had 2 major buying opportunities each year so they were only turning twice a year. It works very well for their business operations, but is not conducive to a sale. As hard as they tried, they could not shift to the 4-6 turns necessary to keep their asking price within a reasonable multiple of earnings. The question that needs to be answered by everyone involved in the transaction is, “Is all of this inventory required to run the business As Is?” If not, they will need to alter their purchasing & inventory management and if so then they likely won’t be able to sell because the multiple of earnings will be far higher than what any reasonable buyer would be willing to pay.

 

 

Jack Crosby

Business Broker at Muradian Business Brokers

First of all if the valuation at 3x seller’s discretionary cash flow and no real estate conveys with the sale, that is a sky-high valuation. My own 14 year average show 2X with no real estate (and 1.6X with R.E.) is the multiple for my market. I have recently been reading that 1.5 is a more correct multiple rather than 2 in this economy. Is your 3 multiple with some real estate—if so, what is the value of the R.E.?

Tom MacPherson

Principal at Summit Acquisitions Group

Top Contributor

I can sell $300K cash flow businesses at a 3 X Cash Flow multiple all day – without R/E. Check out BBS – that’s about the average of sold businesses that size. Plus, I have SBA letters from two banks at that valuation for my client. I think we may end up with a valuation of $300K plus Inventory.

 

 

Jack Crosby

Business Broker at Muradian Business Brokers

Tom, my hat is off to you! That is a sensational record and you must have a lot of very happy sellers—kinda like hitting the lottery! My 14 year average is exactly 1.98X cash flow. This includes many $900k sales as well as well as too many $100k tar-baby projects. I have seen the 2x multiple on a Business Brokerage Press newsletter not very long ago. This is with normal levels of inventory and basing the multiple strictly on the cash flow. I recently a fine restaurant listed–maybe the top in the area and had it listed for 2.5X cash flow but that was because it had an extrordinary amount of cash value in decorations and top-drawer seating & kitchen equipment. But at 2.5x I got almost no inquiries. After dropping it to 2.1 times I had a full price offer in one week. Any other folks that can chime in here with your own experience with multiples in cases with no real estate?

 

 

You may want to consider joining the LinkedIn group called American Business Brokers Association or ABBA.   The membership is mostly made up of those who sell companies and on occasion you get some really good insight from the group.

 

 

 

 

 

 

 

 

About KC Truby

From their ranch in Wyoming, KC and his wife Linnea have bought or started 21 companies as a side line to their accounting business leading them into M&A as a full time business in 2012. These companies are located all over the Western Rocky Mountains, London and India. Since 1969 through their accounting and training companies, KC has taught 18,000 business owners how to improve cash flow and find more customers by installing standardized systems in their small business. Since 1989 KC has presented over 1,000 seminars and training classes to the small business owner.

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