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Inventory Value: Reality or Myth?

This article is about illusions, harbored by a minority to be sure, that the real value of inventory is more than its carrying value. We don't mean to impugn the integrity of business professionals who hold this view. Many companies do have undervalued inventories, or to put it more judiciously, conservatively valued inventories. Indeed, there are many business professionals who insist on conservative valuation because it is sound practice and to do otherwise would create an unnecessary tax liability.

However, when an acquisition is being investigated, there is often significant value placed on the inventory as part of the agreement to purchase; and too often this value has proven to be less than originally expected.

Consequently, despite the compelling incentives in the tax laws to undervalue inventories, many buyers have a jaundiced perspective on the real value of inventories. Are they correct?

What are the typical problems that buyers (and lenders) see in inventories? Here is a partial list:

Inventories often include slow-turning items, even if the overall turnover is good. A mill supply house that has a large stock of snow shovels on March 31 is probably going to have them for a long time, even though they are of good quality
The concept of "lower of cost or market" is no guarantee that the new owner (who can be a buyer or a lender) will be able to sell at that price
Inventories are often of balance, and when a company begins to decline, they are destined to remain imbalanced as the company is able to replace all parts it uses
Perpetual records are sometimes inaccurate

Inventory is often categorized appropriately for financial statement purposes but inappropriately for liquidation purposes. For example, raw materials used in assembly operations are really parts of some subassembly process. This material can be used only in the manufacturing of the product. But when a product is discontinued for lack of adequate profitability or because of a shutdown of the business, what becomes of the parts?

A Better Way

The value of inventory may be a function of many factors including competition, turnover, lead time in delivery, number of suppliers, etc.

Start your thinking on inventory value with the mind-set that everyone overvalues inventory all the time. The business managers and owners, evaluators, and banks, have always made the mistake of overvaluing inventory. We expect most people have always known of this fact but few have chosen to take a hard look at the real values. All of us would rather be the bearer of good news than bad news. A high value of inventory gives the appearance of more value for the business and therefore is more desirable. Generally, a realistic appraisal gives less value to inventory and therefore less value to the business.

Liquidation Scenario

Why is liquidation relevant to a growing business? In an acquisition, there are frequently occasions for the buyer to make important changes in the business. To do so often requires discontinuation of certain lines of business. The anticipation that these discontinued lines will generate instant cash flow is often illusory. A hard look at inventories before making the acquisition will often avoid problems in the period immediately following the closing. We would agree that continuing businesses shouldn't be valued in the manner we are about to suggest. But the following proposed analysis may be illuminating.

We have developed a formula that could establish the real value of inventory. It is a simple formula to use, but covers a lot of contingencies.

For example, suppose we have an item with a price (cost) of $1 and a lead time of less than three weeks, with many distributors, and many competitors who sell it or use it. Its value according to the formula is: $1.00 x 70% x 70% x 65% = $.32

The conceptual framework for the formula is simple: the longer the lead time, the fewer the suppliers and the less the competition, the more the inventory is worth. It is not as easy to apply as the turnover ratio, but it is more relevant. Note that an item with a slow turnover is probably going to have the characteristics of a deep discounted item. However, the characteristics shown in the table have more bearing on the current value than the past.

This kind of analysis can be applied to fungible raw materials, as well as parts for assembly. It does not generally apply to finished goods. There are some items at the bottom of the inventory value scale such as nuts, bolts, bits of gaskets, etc. that have no realizable value and should not be subjected to this formula. Their value will be the value of scrap in most analyses.

Although the formula is intended for lenders, and the calculations might not apply to purchase prices, it is relevant to buyers of businesses as well for two reasons. It will give them a new perspective on the value of the inventories they are buying; it will also help them determine whether inventories can be financed.

Naturally, every formula will have exceptions, but in our experience this one works very well most of the time. We hope it proves useful to you. We don't expect you to blindly apply it to all inventories, but it is a good starting point from which to ask the question: "What reason is there not to apply these discounts?" That question puts you on the right path toward real value.

By Fred Rock

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