In many acquisitions, inventory can be a significant asset. In addition, most purchase agreements contain working capital targets that get reconciled after the closing. Therefore, there is usually incentive for sellers to be aggressive with their inventory amounts and policies.
As part of the diligence process, it is important dig deeper into the details around inventory. Small distinctions can make a big difference, not only with the working capital true-up, but also with post-acquisition operations.
A thorough review of the target’s inventory aging and usage report should help identify excess and obsolete inventory that the buyer shouldn’t acquire or pay for. These reports should also be compared to sales projections and backlog reports in order to validate the quality of the inventory. In addition, a review of the target’s product development plans can identify products that will be replaced, and therefore might be an indicator of excess inventory.
The target’s internal accounting policies may also have an impact on what is being purchased. For example, some companies may make modifications, drill holes, stamp etc., to raw materials in anticipation of future manufacturing, but do not change the classification on the books and records. There is a significant difference between unaltered raw materials, especially commodities, and those that have been altered. In this instance the buyer is really getting work in process and not raw materials. The use, and therefore, the value of those goods may be diminished. A complete review of policies confirmed by a walkthrough of the facilities should help shine some light on these practices.
Inventory in an acquisition deserves a close look along with detailed analysis in order to ensure a fair deal.