How to Value Inventory when Buying a Business
“Buying a business can be a complicated process. There are many aspects that can cause failures in the negotiations between sellers and buyers or cause animosity between the seller and the buyer. One such area is the valuation of the business. Determining the worth of a business is a crucial and critical aspect of the buying process. If the buyer buys a business that is overvalued then, the buyer is paying more than what the business is worth. On the contrary, if the buyer buys a business that is undervalued then, the buyer will wonder if the business is failing.”
Take the case of valuing the inventory of a business for sale. What should the buyer include in the inventory? What valuation method should the buyer use? In most industries, the value of inventory is added above the asking price of the business for sale. Here are some pointers on how to value inventory:
1. The potential buyer and seller should agree on which valuation method to use for inventory. This could be by using:
a. The original purchase price or vendor’s invoice
b. The current value of the items.
The latter is the simpler and more realistic method. Using the original purchase price may not reflect the actual value of the assets.
2. The final count and valuation of the inventory should be done at the close of the sale, since the amount of inventory during the purchase process is usually different.
3. There should be an anticipated value for the inventory between the seller and buyer. This value will more or less reflect the closing value of the inventory, which will be adjusted accordingly. This is done to avoid disagreements between the two parties. This will also ensure that the buyer has some inventory sufficient for a few months’ worth of operations when he or she takes over the business.
4. If the buyer is not sure which particular items can be valued as inventory, consult with an accountant. Inventory includes products and materials that can be resold or used in servicing a client. Inventory is different from other hard assets such as machinery, equipment and furniture.
5. The buyer must insist on the physical count of the inventory. The business may have inventory control software but because of input errors, glitches or unaccounted losses, there may be some discrepancy with the actual inventory.
6. Determine the quality and condition of the items – which items are sale-able and should be included in the valuation. The buyer can negotiate items that are difficult to sell, such as those that are no longer in demand, should be valued for half the cost. Other items that are not of interest or not compatible with the target market could be excluded from the valuation.
7. If the buyer and the seller have a friendly relationship, the buyer can conduct the inventory count, or at least a part of it. This applies mainly for companies with a small inventory list.
8. Bring in an outside inventory service firm that will count the items, determine the cost and calculate the value of the inventory. This is a wise move especially if there is some animosity between the the buyer and the seller, or if the seller and buyer do not want to take the time and energy to count the inventory themselves.
Valuing inventory is important. The buyer or a qualified representative should be present during the examination of the inventory. Knowing what is available and the status of inventory is crucial for the valuation of the company. If the buyer does not agree to the price tag set by the seller then, negotiation is necessary.