Recently, I was working on a transaction where I was helping a buyer with the acquisition of a multi-location retailer. When we started to evaluate the business we learned that a significant portion of its inventory was aged beyond three years. The business owner argued that it was the nature of the business for some inventory to move more slowly, and that when it eventually sells to a customer it will be at a full retail price or perhaps only slightly discounted from original retail.
However, that ignores the opportunity cost of having capital tied up in slow-moving inventory. For example, if I paid $100 for a piece of inventory that I plan on selling for $150, and then it takes me five years to sell that piece of inventory, the present value of the retail price, if using a 20% discount rate, would be $60 – in other words from a financial analysis / opportunity cost standpoint, in essence, I lost $40 on my investment. If I had to hold it another five years before selling it (and assuming I don’t discount it at that point in time to get it sold) the present value would only be about $24, for an effective loss of $76.
Another simple conceptual way of looking at this is if I buy a piece of inventory for $100 and plan on selling it for $150 and it takes me five years to sell it, I made a $50 gain before SG&A expenses (or 50%), but that really equates to only about a 10% average gain per year because of the long holding period. If, in contrast, after one year I liquidated the piece of inventory at cost, and then reinvested that into an item that turned three times at a price of $150 over the next four years, then that original $100 investment generated a $150 gain over that same five year period, for an average annual gain of 30%.
Even if you believe that your significantly aged inventory continues to be relevant, if it has not sold in 2-3 years, how much longer will it age before someone buys it? Is it prudent to hold onto inventory that may continue to sit on the shelf for years, when instead that capital could have been devoted to more marketable items?
While you may not be concerned about aged inventory, a business buyer will be. Business buyers typically pay full price for inventory that is current, but when it starts aging beyond a year (depending on the industry - in some - like fashion retailers it may be less time) there is usually a healthy discount (often 50% for 1-2 year aged inventory) and/or if it gets beyond 2-3 years many business buyers don’t want to buy it at all, and sellers often just throw it into the deal at no cost.
Here are links to a couple of additional articles on this topic related to retailer inventory:
Winning Strategies for the Retail Industry The Bottom 20