Why it matters
Stock (inventory in the US) is often priced separately from the rest of the business, or included at a stated value. Loupe's valuation tool shows inventory at cost as an addition to the value rather than blending it into the multiple, so the figure you accept for stock goes straight into what you pay.
Stock that has sat for a long time is often worth less than it cost. Clothing goes out of season, electronics are replaced by newer models, food and cosmetics pass their dates, and spare parts outlast the machines they fit. Accounting rules generally require stock to be carried at no more than it can be sold for, after the costs of selling it, but in smaller businesses write-downs are often late or never made.
That creates two problems. You pay cost for goods that will sell at a discount or not at all. And if old stock was never written down, past profit was higher on paper than in reality, so the earnings you are valuing are overstated as well.
A large write-down in recent accounts is worth understanding too. It may be a genuine one-off, or it may point to a buying problem that will happen again. If the seller has added it back as a one-off, check whether earlier years had similar losses.
Here is a fictional example. Brackenhollow Outdoor, an online outdoor gear shop, lists its stock at A$400,000 at cost. Its ageing report shows that A$120,000 of that has not sold in over a year. If clearing those lines recovers half their cost, the stock is worth nearer A$340,000, and a buyer who paid A$400,000 has overpaid by A$60,000 before trading a day.
Inventory at cost is stock valued at what the business paid for it, not at the price it expects to sell it for. It is the usual basis when stock is added to a purchase price.
How to spot it
- There is no stock ageing report, or the stock figure has barely changed for years.
- Stock is growing faster than sales.
- The business runs frequent clearance sales or deep discounts.
- The accounts show a large write-down that has been added back.
- Stock is valued at original cost regardless of age or condition.
- A visit to the warehouse or shop floor shows dusty, damaged or discontinued lines.
Questions to ask the seller
- How much stock is older than six months, and how much is older than 12 months, by product line?
- How is stock valued, and when was it last written down?
- When was the last full physical count, and who carried it out?
- Can unsold stock be returned to suppliers, and on what terms?
- Which stock is included in the price, and how will it be counted and valued at completion (closing in the US)?
- Are any lines discontinued, expired or close to expiry?
Documents to request
- A stock ageing report by product or SKU
- The latest physical stock count and its reconciliation to the accounts
- The stock valuation policy and a history of write-downs for the last three years
- Sales by product for the last 24 months
- Supplier terms covering returns of unsold stock
- The draft clause in the sale agreement that sets how stock is counted and valued at completion