In a strategically managed manufacturing company, the possibility of selling the business should always be in the back of leadership’s mind, if not the front. But far too often, companies haven’t prepared themselves to take advantage of an opportunity because their inventory is not well controlled.

When potential acquirers look at a prospective business, inventory quantity and valuation are common risk areas. What follows here are some questions for leadership to ask to determine if they’re ready for an opportunity to sell. We’ll also look at best practices to fix deficiencies and explain what occurs during merger and acquisition (M&A) due diligence.

Due Diligence Process: Inventory Quantity

In the due diligence process prior to a sale, it’s rare for a physical count to take place before closing. What can be expected are questions about the reliability of inventory tracking methods of the selling company, as well as any known areas of concern (such as historical count differences).

Questions leaders should ask about inventory.

  • How often is inventory physically counted?
  • How much does the inventory count vary from related company records?
  • What accounting adjustments have been made to inventory?
  • Why were the accounting adjustments necessary?

Most manufacturing companies have a perpetual inventory system that keeps an ongoing count, but leaders should ask themselves if they trust the system. The double check can be a physical count.

If your method is a periodic full physical count, it’s important to do so as near the end of an accounting period. If you’re counting at year-end, try to count on Dec. 30 and adjust for any receipts/shipments that occur on Dec. 31. Or count on Jan. 3 and roll back activity to the period end. This minimizes the opportunity for errors to build up in the interim.

Another method is cycle counting, where a smaller group of items is counted each month (or week or even every day). Everything will be counted eventually, but the majority of each count focuses on key items. For example, items could be broken down by value into categories A, B, C and D, with all category A items counted each month, 50 percent of Bs, 20 percent of Cs and 5 percent of Ds. A cycle count is less disruptive to operations. For example, production and shipping departments don’t have to shut down as they typically would during a full physical count.

During the M&A process, a physical count typically takes place later as a condition to close and/or part of the working capital “true up,” potentially impacting the overall consideration exchanged for the business. The current or future accounting firm should be involved in this count to observe procedures and adjustments in order to rely on the inventory for opening balance sheet purposes.

Financially speaking, would-be purchasers view relatively high inventory levels as an immediate payback opportunity. If a buyer is able to reduce investment in inventory, they can pull out money in cash from working capital, which may affect what they’re willing to pay for the business. Building or maintaining inventory requires cash, so if the buyer could reduce the days of inventory on hand by five days, that could mean dollar for dollar payback.

Operationally speaking, inventory organization and stock levels provide insight into plant efficiency and potential costs post-close to train and upgrade people and processes. The prospective purchaser will want to know how much they will have to change when they take the reins, how much it’s going to cost and what the payback period is.

Due Diligence Process: Inventory Valuation

Questions leaders should ask about inventory value.

  • How does the company calculate the price assigned to a product when it’s inventoried?
  • Assuming a standard cost accounting system, how often are the standards updated (including labor and overhead applied to inventory cost for work in process and finished goods)?
  • Does the company appropriately capitalize in-bound freight and variance accounts into inventory each month?

Initial inventory value includes the cost of the goods and the costs of bringing them in. That should all be capitalized, according to U.S. Generally Accepted Accounting Principles (GAAP), but most companies expense in-bound freight costs. At merger/acquisition time, that creates a complication, prompting the need for a quality of earnings expert to be brought in to translate accounts from the previous practice.

Many companies also haven’t adequately estimated their inventory reserves. What is the policy for slow-moving, excess and/or obsolete inventory? For example, to assure good customer service, a company may keep extra items in stock, but sometimes those stocks are too large and items sit in inventory for long periods. If an item isn’t going to be used for five years, can it really be valued at 100 percent, considering the likelihood of selling the item and the time value of money?

During diligence, a great deal of emphasis will be placed on inventory valuation. Those conducting diligence will dissect the cost-accounting entries (walking through the costing from receipt through assembly to finished goods and the release of inventory at shipment).

Costs that can be inventoried will be analyzed using average inventory turnover to estimate the amount of reported manufacturing expenses that should have been capitalized as inventory at any given balance sheet date.

Experts will take usage reports and quantify how many years of coverage the company has per stock keeping unit (SKU) based on average annual usage. The recorded reserve will be compared to the estimate of the value of inventory that won’t be converted to cash in the near term.

These findings will directly impact quality of earnings and working capital. Non-GAAP accounting for inventory could potentially change earnings before interest, tax, depreciation and amortization as well as the valuation of the company/purchase price — either positively or negatively.

Post transaction close, the findings of the due diligence process can also affect gross profit. Almost all manufacturing business owners look at gross margin as part of their standard operations review; however, many of these unaudited and/or lower middle market companies may not be calculating gross profit correctly. Accounting for inventory in accordance with GAAP can materially change reported gross profits. It’s important to keep these changes in mind when comparing to prior months or budgeting for the future.

Implementing changes from prior practices to GAAP-based accounting for inventory may result in material changes to the net inventory balance recorded on the balance sheet. Whether increasing the balance with additional capitalized costs or decreasing with additional reserves, getting to GAAP is key for both buyers and sellers.