Knowing the value of a product is crucial to selling the product. However, the value of a business is also determined by the value of the inventory.
Purchasing a business does not always mean simply taking over a building, but also acquiring some of the assets that the business holds. This means that in order to sell a business at fair value, all inventory must be accounted for and appraised.
Main street businesses may wonder why they should have a business valuation. While the process will provide a potential buyer with a price tag, it will also give insight to the potential earning power of the business, as well as assess the risks associated with it. This might be necessary before applying for a loan, but it also provides valuable data when planning for the years ahead.
Here are some things to keep in mind when calculating inventory during a small business valuation:
1. First, the buyer and seller must agree on an inventory model. For bulk products, there are two small business valuation methods:
- FIFO (first in, first out), meaning that the value of each item is based on the invoice recording the purchase of the first unit of inventory.
- LIFO (last in, first out), means that the costs of the most recently acquired unit of inventory determines the cost of each item.
When prices are rising, it is most effective to use LIFO, because the cost of inventory charged to expense is high, creating the smallest amount of taxable income.
2. The final count and valuation of inventory should be done at the close of the sale, when the amount of inventory has finalized. During the purchase process, inventory usually fluctuates due to ongoing business by the seller. Before the final value is established, an anticipated value of inventory should be discussed between the seller and buyer in order to avoid disagreement. This also assures the buyer that there will be sufficient inventory for operations while they take over the business.
3. Only items that can be sold to or used to service a client can be considered inventory. Machines, equipment, and furniture are considered hard assets and may not qualify.
4. A request for physical count of inventory is usually recommended for the buyer.
5. The demand and condition of the items can be taken into account during the valuation. Things you don’t want to sell, things that are no longer in demand, or items that don’t align with your consumer demographics can be excluded from the appraisal.
6. If the buyer and seller conduct the inventory count together, the seller is able to explain some business practices. This is valuable if the buyer and seller are on friendly terms. If not, or if the process is simply too time consuming, an independent agency can be hired to count inventory.
A company valuation is important in order to determine if the price tag set by the seller is fair. Want to know how much a business is valued at? Start your free trial of Banker Valuation today and run a small business valuation in just minutes.