Hey there,
Today, I want to dive into a great question I received from Anton about evaluating a business and how inventory fits into the equation. Let's dive into it!
The Question:
When assessing a business, should the value of inventory be added on top of the multiple of cash flow in determining its overall worth?
Understanding Enterprise Value:
When we calculate cash flow multiples, we arrive at what's known as enterprise value. Enterprise value encompasses everything necessary to make the business operate efficiently, from machinery to equipment and more.
The Role of Inventory:
Inventory is a vital part of a business's operating capital, alongside assets like cash and receivables. However, how inventory is treated by lenders for collateral purposes depends on its nature.
Fungible vs. Non-Fungible Inventory:
Fungible Inventory (e.g., Lumber): Banks are more likely to lend against this type of inventory, considering it as security. It can be liquidated if needed.
Non-Fungible Inventory (e.g., Fashion): More challenging to finance due to its perishable or seasonal nature. Banks might be less willing to use it as collateral.
Net Normal Position in Working Capital:
The enterprise value already includes the net normal position in working capital. This refers to the amount of equity an owner typically needs to support working capital. It considers factors like inventory, receivables, payables, and the owner's cash.
Businesses that have been successful for a long time are often over-capitalized with working capital. What the current owner has done may be very different from how you’ll need to operate.
Asset Sale vs. Share Sale:
Asset Sale: The buyer acquires equipment, machinery, leaseholds, and inventory. The buyer must secure their line of credit to support the inventory since debts and lines of credit aren't transferred.
Share Sale: Inventory, payables, and receivables usually come with the company. Working capital adjustments are made during the transaction.
Implications for Buyers:
Fungible Inventory: In businesses with highly fungible inventory, a significant portion is likely added to the cash flow multiplier.
Non-Fungible Inventory: For businesses like produce stands or fashion boutiques, the entire inventory may be factored into the cash flow multiplier, as it can't stand as collateral for lenders.
Understanding the dynamics of inventory in business valuation is crucial. It impacts the negotiation process and the overall financial strategy for the buyer.
If you found this explanation helpful, you'll appreciate the in-depth case studies and insights in my online course.
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Cheers! 🥂
David Barnett
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