The Balance Sheet : Inventory
September 11, 2007
If the business you’re contemplating buying is a service business, you won’t have inventory to worry about, but if you’re thinking of buying a business that manufactures and/or distributes products, you’ll be faced with the problem of valuing and dealing with the seller’s inventory.
On December 31, 2003, Houston Sash & Door had $203,841 in its inventory account. Does this mean that the inventory is worth $203,841, or that it could be sold for $203,841? Neither. Since the balance sheet records only what was paid for assets, it provides us with hardly a clue about what inventory is worth or what it can be sold for, if at all! Houston’s inventory may be worth far more than $203,841, far less, or zero. How is this possible? Very often, inventory decreases in value as it sits on the shelves.
If a competitor comes out with a new product, improves a product, or produces the same product for less, your inventory becomes that much less valuable. Here’s a rather extreme example that proves the point: In the 1970s the federal government prohibited the sale of children’s pajamas treated with the chemical TRIS. If you had a row of shelves stocked with TRIS-treated pajamas, what would your inventory be worth? Unless it had value as rags, probably zero. When inventory becomes unsalable, or can’t be sold because it’s been stolen or can’t be found, the business’s accountants should write down the inventory, that is, change the figures on the balance sheet to a lower amount. But unless you’re dealing with the extreme example of the government prohibiting the sale of an item, whether an item is unsalable or not is highly subjective. An owner is not likely to write down inventory “nailed to the shelf” if a sale of the business is in the offing. It’s another example of prettifying the books.
Not only doesn’t the balance sheet tell you how much the inventory is worth, it doesn’t tell you what it is. To an accountant, inventory can exist in three stages: as raw materials (such as Houston Sash & Door’s raw lumber), as work in process (the lumber being made into windows and doors), and as finished goods (the completed windows and doors). Obviously, the value of raw lumber isn’t as great as the value of a finished door. If all your inventory were in the form of completed doors and windows, all you would have to do is sell them. If all you had was raw lumber, you would have to incur the expense of converting the lumber into finished goods. You and your accountant should check how much of the inventory falls into each category. When we get to Chapter 11, which deals with all the steps that should be taken before a sale is closed, we’ll see that one of the steps is to actually count the inventory on hand shortly before the closing.
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