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How Much Inventory is Included in the Asking Price of a Business?

Inventory is an important consideration when buying or selling a business, as it is common to include some level of inventory in the asking price. Sheila Spangler, a Certified Mergers & Acquisitions professional, responds to one reader’s question on this topic while sharing best practices on how inventory is valued and included in the asking price.

“I just read your article published on BizBuySell SDE vs. EBITDA Multiples To Value or Price a Business For Sale and was left wondering if inventory is typically included or excluded in the sales price developed using a multiple of EBITDA or SDE?”

Thanks for the question. You bring up a good point regarding inventory. The best answer is, “it depends”. The first step is to ask the listing broker (or seller) how much inventory is included in the asking price. Typically, when a professional business broker lists a business, a “normal” amount of inventory is included in the asking price. However, in my experience, no matter what amount of inventory is included in the price, the buyer generally still wants to negotiate the amount.

What is a normal amount of inventory? That is the amount determined by the seller and advisors when pricing the business for sale. However, some advisors and sellers do a better job of determining the inventory amount than others. It “should be” the amount of inventory that a business typically has on hand or uses for normal business operations.

To determine a normal amount of inventory, I recommend calculating inventory turns for the business and then comparing those turns to different balance sheet time periods for the company, such as quarterly or the fiscal year ends. Understanding the inventory cycle is important, especially if the business has seasonal inventory fluctuations or if you suspect there may be outdated or excess inventory. To get a deeper understanding of the subject company’s performance, you may also consider comparing its inventory turnover to those of its industry peers. This provides you with a method to determine if the subject company is an average, above average, or below average performer when it comes to inventory management. If above or below average, you’ll want to dig deeper into the financials and ask questions about inventory management. High inventory turnover can indicate greater liquidity. Low inventory turns can mean excess inventory or unsellable inventory that has gathered dust in the warehouse. An inventory turn, or inventory turnover ratio, describes the number of times inventory is “turned over (sold and replaced)” during the year.

Reliable Resources for Benchmarking a Company’s “Ideal” Inventory

What is a good resource used by industry professionals? There are several, including Bizminer and Integra. I use Risk Management Association (RMA) for financial statement benchmark comparison. Each industry is categorized by an NAICS code. A NAICS code is associated with every company in the United States and sometimes a company may have characteristics of more than one code. However, for financial analysis (and business valuation) purposes, one code is selected as the best comparison to the subject company. For example, a Plumbing, Heating and Air Conditioning business is categorized in the NAICS code 238220. If the business you are considering doesn’t offer plumbing services but does offer heating or air conditioning services, this is still the code used.

The 411 on Risk Management Association (RMA)

RMA data is a highly regarded analysis tool used by many commercial lenders, valuation analysts and appraisers to compare the subject company offered for sale to others of similar size in the selected industry.

RMA compiles data from financial information submitted to banks and other financial institutions from commercial customers and prospects during the loan underwriting and approval process for all types of commercial credit transactions, including credit lines, term loans, and other credit facilities. This peer data is generally accepted by business appraisers as representative of the industries in which RMA reports and is considered a reasonable source of comparative financial data.

The RMA data pool is limited to those companies that have applied (but not necessarily received approval) for a loan or credit line from an RMA member financial institution. RMA provides data segmentation by revenue size, asset size, and location. Access to the data is available by subscription. If you are looking at one or two business opportunities and are curious about how the subject company compares to its peers, you may consider asking your local lender, business broker, or appraiser if they would be willing to pull a report on the industry for you but please don’t abuse this. If you are working with one or more of these advisors, they may be willing to help you get access to this information if they can.

How Risk Management Association Develops Industry Benchmark Data

Commercial lenders input the financial information from the business financial statements or tax returns into a spreadsheet format designed to determine what is most important to a bank, and that is the available cash flow generated by the company to service debt. When evaluating a company’s liquidity, bankers want to understand which current assets will turn into cash in 12 months or less.

This is also what a business buyer wants to know. Current assets that won’t convert to cash in 12 months or less are spread as “non-current assets” thus giving a better picture of working capital and inventory, for example. This is a more conservative view than financial statements prepared according to GAAP (Generally Accepted Accounting Principles).

In other words, if the inventory doesn’t turn in one year or less, and depending on the product and the industry, this can indicate excess and perhaps stale (unsellable) inventory. This information is critical for both bankers and business buyers before making a decision to lend money or buy a business. By the way, current assets include cash, accounts receivable, and inventory. Current assets minus current liabilities is the standard definition of working capital.

How to Calculate Inventory Turnover When Analyzing a Business

So, what is the formula to calculate inventory turns? Here’s the definition and advice from RMA’s Annual Statement Studies handbook:

Cost of Sales/Inventory

How to Calculate: Divide cost of sales by inventory.

How to Interpret: This ratio measures the number of times inventory is turned over during the year.

High Inventory Turnover — On the positive side, high inventory turnover can indicate greater liquidity or superior merchandizing. Conversely, it can indicate a shortage of needed inventory for sales.

Low Inventory Turnover — Low inventory turnover can indicate poor liquidity, possible overstocking, or obsolescence. On the positive side, it could indicate a planned inventory buildup in the case of material shortages.

Cautions — A problem with this ratio is that it compares one day’s inventory to the cost of goods sold and does not take seasonal fluctuations into account.

Please note — For service industries, the cost of sales is included in operating expenses. In addition, note that the data collection process does not differentiate the method of inventory valuation.

How to Calculate the Days’ Inventory: Divide the cost of sales/inventory ratio into 365 (the number of days in one year).

365/Cost of Sales/Inventory ratio

How to Interpret the Results: Divide the inventory turnover ratio into 365 days to yield the average length of time units for the inventory.

Other Factors to Consider When Calculating Inventory

When determining the price at which a business may sell, the inventory turn ratio is only one piece of a complex puzzle. Keep in mind, a couple of calculations won’t necessarily tell you all you need to know. You must dive deeper into the financials and ask questions about the typical sales cycle, buying policy, inventory management controls, etc. If, after doing your analysis, you determine that the seller’s “normal inventory” amount appears too high or low as compared to industry, you will have a factual basis to have a rational discussion with the broker and the seller.

A few years ago, I represented the owner of a tool and equipment company that had $1,000,000 of inventory that the owner believed was “good”. However, this particular inventory included items purchased on close out sales consisting of outdated models, sets of tools with one piece missing, etc. While I empathized with him that these items may be sellable to someone, they did not represent “normal inventory” that could be included in the sales price.

Thus began a long series of conversations to help him understand that the normal inventory turned over several times per year but the other items (with missing pieces, or outdated models) were not going to sell in the normal course of business and could not be included in the asking price. I suggested he hold a separate “inventory reduction” sale to try to get rid of these odd pieces. Long story short, I sold the business with the normal amount of inventory. Inventory that has been in the warehouse for years, gathering dust, is not part of normal inventory, no matter the condition or how “good” it might be.

As a business buyer, you must investigate/analyze the financials to determine the earnings and how the business was priced. The price being advertised may or may not include a normal amount of inventory. It “should”, but what should be done and what is actually done are often two different things. The benefit of working with a professional business broker is that they want to make sure that you, as a buyer, get accurate information. Doing so assists in selling the business which benefits all parties. However, you, as the buyer, are ultimately responsible for assessing the information provided. So, dive into the financials and calculate those inventory turns!

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