The Role of Inventory in Manipulating Business Valuations

When financially evaluating a business, especially in the context of mergers and acquisitions, inventory can play a significant role in determining the value of a business.

However, as I saw just this week with one of our clients, inventory can also be manipulated to present a more favourable (or unfavourable) picture of a company's financial health. In this particular example the closing stock in the income statement (Profit & loss account) differed significantly to what was stated in the Balance Sheet.

Gross margins as a result were overstated by ￡92k, and therefore so was the EBITDA. This artificially increased the value of the business that had been prepared by the seller’s accountant.

Perhaps they thought we were born yesterday?

In this article I want to go through inventory and how it can make a difference in mergers and acquisitions

Understanding Inventory Valuation Methods

There are several methods for valuing inventory, each with its own impact on financial statements:

1. First-In, First-Out (FIFO): This method assumes the oldest inventory items are sold first. In times of rising prices, FIFO results in lower cost of goods sold (COGS) and higher profits.

2. Last-In, First-Out (LIFO): Here, the most recently acquired inventory is sold first. During inflation, LIFO produces higher COGS and lower profits, which can lead to tax benefits.

3. Weighted Average Cost: This method averages the cost of all inventory items. It smooths out price fluctuations, leading to more stable profit margins.

Manipulative Tactics

?? Overstating Inventory Levels: As we have seen above, companies might inflate their inventory levels to boost asset values. This can make a business appear more valuable on paper, though it's a house of cards that can collapse under scrutiny.

?? Undervaluing Inventory: Conversely, a company might undervalue inventory to reduce tax liabilities. While this can save money in the short term, it may negatively impact the perceived value of the business during a sale.

?? Changing Inventory Valuation Methods: Switching between FIFO, LIFO, and Weighted Average Cost can manipulate profits and asset values. For instance, moving from LIFO to FIFO in a rising price environment can increase reported profits, making the company look more profitable than it actually is.

?? Obsolete Inventory: Failing to write down obsolete or slow-moving inventory can artificially inflate asset values too. This misrepresentation can mislead potential buyers regarding the true state of the business's inventory.

Red Flags for Buyers

Buyers should be vigilant for signs of inventory manipulation. Here are some red flags:

? Unusual Inventory Growth: A sudden spike in inventory levels without a corresponding increase in sales can indicate manipulation.

? Frequent Changes in Valuation Methods: Companies that frequently switch their inventory valuation methods may be trying to manipulate their financials.

? High Levels of Obsolete Inventory: Large amounts of outdated or unsellable inventory can signal that the company is not accurately reporting its inventory.

Mitigating Risks

To mitigate the risks of inventory manipulation, buyers can:

? Conduct Thorough Due Diligence: Carefully review the company's inventory records, valuation methods, and financial statements. Look for consistency and transparency.

? Hire Inventory Specialists: Engage experts to assess the physical inventory and ensure it matches reported levels.

? Review Historical Data: Analyse historical inventory and financial data to identify any unusual patterns or discrepancies.

? Inspect Inventory Practices: Understand the company's inventory management practices, including how they account for obsolete and slow-moving items.

Conclusion

Inventory manipulation can significantly distort a business's valuation, affecting both buyers and sellers.

By understanding the tactics used to manipulate inventory and taking steps to identify and mitigate these risks, parties involved in mergers and acquisitions can make more informed decisions and protect their investments.

Always approach inventory figures with a healthy dose of skepticism and a rigorous review process.

#BusinessValuation #InventoryManagement #MergersAndAcquisitions #FinancialTransparency #DueDiligence