Accurate inventory reporting is crucial in due diligence. Without it, the buyer can’t trust the reported margins and overall earnings.
Inventory management is a major challenge for many businesses. The COVID-19 pandemic disrupted global supply chains, causing delays and shortages. Tariff and economic uncertainties have led to increased costs and pricing volatility.
Yet, with all the time and energy spent managing inventory and protecting margins, many owners fail to recognize a basic inventory risk that could cost them millions — the inability to maintain accurate and reliable inventory records for financial reporting.
Accurate inventory reporting is a crucial aspect of due diligence. It provides transparency, fosters confidence, and improves decision-making. Without it, a potential buyer cannot gain comfort in a target’s reported margins and overall earnings.
Explore the significance of precise inventory reporting, the risks of inaccuracies, and the recommended practices to maintain integrity in inventory management.
How poor inventory management hurts business purchase price
We see numerous cases each year of companies trying to sell their businesses where poor inventory management kills the deal or significantly reduces the purchase price. Here are a few examples:
- An aerospace and defense manufacturer conducted an analysis to restate its historical inventory values and assess the effects on earnings. The standard costs assumptions applied in this process did not accurately reflect capitalized material, labor, or overhead. The buyer’s due diligence indicated inventory at the end of the reporting period was overstated by $1.5 million. This finding contributed to a price adjustment of over $8 million.
- An industrial distributor recorded inventory as an expense upon purchase and didn’t conduct inventory counts. Supporting documentation was not available to determine historical inventory balances. As a result, reported margins were considered unreliable, leading the buyer to require a physical count, additional analysis, and a multi-million-dollar reduction in the purchase price.
- Unit of measure errors in the inventory detail of a large manufacturer led to overstating inventory and earnings. Additionally, inventory schedules didn’t tie out to the general ledger. Correcting these issues resulted in a decrease to reported earnings and a substantial reduction in the transaction price.
- Overstated inventory was identified as part of working capital calculation post close. The overstatement required the seller to pay the buyer for the overstatement. Had this been identified and corrected earlier, the working capital target would have been set lower and the seller would not have to return a significant portion of their proceeds.
The role of inventory reporting in due diligence
Inventory reporting is the process of documenting and verifying the inventory held by a business. This includes the quantity, condition, and value of goods. Precise inventory reporting is vital in various business scenarios, including mergers and acquisitions (M&A), financial audits, and internal controls. Accurate inventory data offers a clear picture of a company's operational efficiency and financial health.
Enhancing transparency and trust
In any business transaction, transparency and confidence is key. The quality of inventory reports support the reasonableness of a company’s cost of goods sold and overall financial results. This helps to build trust between the involved parties, whether they are potential investors or business partners.
Informed decision-making
Accurate inventory reporting allows stakeholders to make well-informed decisions. For instance, during an M&A process, prospective buyers need to assess business earnings to determine the fair purchase price. Inaccurate reporting could lead to overvaluation or undervaluation of the company, affecting the transaction's outcome. In some cases, the inability to properly support the financial performance accuracy prevents a buyer from moving forward with a deal.
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Risks of inaccurate inventory reporting
Inaccurate inventory reporting can lead to significant risks and consequences. These can impact various aspects of a business, from financial performance to reputation.
Financial discrepancies
Inventory is a major component driving a company’s cost of goods sold. Misreporting inventory levels or values can lead to financial discrepancies, affecting the balance sheet and income statement. This can result in misstated working capital and earnings, potentially leading to loss of investor confidence.
Operational inefficiencies
Accurate inventory data is essential for efficient supply chain and logistics management. Inaccurate reporting can lead to stockouts, overstocking, and production delays. These issues can disrupt operations, increase costs, and create volatility in financial performance. These inefficiencies can severely affect a company's bottom line and the ability to demonstrate what the normal earnings of the business are to a potential buyer.
Reputation damage
Inaccurate inventory reporting can damage a company's credibility and trustworthiness. This can have long-term repercussions, as stakeholders may be hesitant to engage with a business prone to inaccuracies or owners who don’t appear to understand a key part of the business.
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Recommended practices for accurate inventory reporting
To mitigate risks and improve inventory reporting, businesses should consider these recommended practices.
- Conduct regular counts and inspections. Evaluate and address unusual variances.
- Implement inventory management systems and verify the data going in is accurate.
- Train employees on inventory management practices and create an environment of accountability.
- Leverage technology and automation to enhance inventory tracking and reporting accuracy.
- Maintain historical count detail even if done via a spreadsheet or some other manual method.
How CLA can help with inventory reporting
Accurate inventory reporting is essential for a successful transaction outcome. Without it, you may not truly know the value of your business.
CLA’s experienced inventory management consultants can help you build the processes required to deliver timely and accurate inventory counts. For many years we’ve been helping businesses automate and consolidate their inventory control systems. Reach out to learn how your company can improve its inventory reporting.