Published: Lessons Learned - Mergers & Acquisitions, January 2011

Lessons Learned
By Robert Belcher, CPA

Our manufacturing client was concerned that the reported net income of the target be a true representation of profitability. The purchase price was based on a multiple of EBITDA.

In evaluating the inventory costing method, we performed testing and recalculated the inventory valuations. Results showed that the inventory amounts reported by the seller were overstated. The seller had not updated the inventory costing methodology in several years, causing the amount of labor and overhead applied to the finished goods inventory, as well as work in progress inventory, to be significantly higher than the costs incurred by the company to produce their products.

Due diligence also revealed a significant amount of obsolete inventory that had not been written down to fair market value. The company had discontinued several products but had continued to value these inventory items at full cost.  Evaluations on accounts receivable resulted in an increase to the reserve for doubtful accounts, which should have been written off.

Recalculating the inventory and accounts receivable resulted in a $2,000,000 decrease to the EBITDA reported by the seller. Our client used the revised calculation in price negotiations and the purchase price was approximately $2,000,000 lower than originally offered.

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