The LIFO accounting method can have a big impact on distributor valuations.
Thinking of selling your company? The taxman may have a lot to say about what your company is worth if you use the LIFO (Last In, First Out) accounting method. Along with the dearth of serious acquirers with cash in hand, the drop in prices for key commodities such as copper, aluminum and zinc, and the overall economic environment, LIFO's impact on valuing inventory can have a serious effect on the value of your business. It can impact how you manage your inventory and cash flow, negotiate with suppliers, handle returns of excess material and inventory and potentially focus more on running the business for profit rather than for revenue and market share growth.
Many distributors operate their business with the LIFO accounting method because LIFO enables them to enjoy a “tax deferral.” Distributors and other small businesses had hoped this would be a permanent tax deferral because of ever-increasing costs to replace product that was sold. But LIFO may not be as permanent an accounting tool as these distributors may hope — President Obama has called for its repeal in the recent budget he sent to legislators on Capitol Hill.
The new legislative and economic realities, as well as an overall decline in material prices, may affect distributors' business valuations and possibly their tax situations. One of the most dramatic areas of impact is that when your company sells the same number of units for less revenue, cash flow can become a concern. In this type of deflationary environment, new inventory costs less than existing inventory. When you pay less for new inventory than for the older inventory you have on the books, it can contribute to cash-flow problems. You generate less profit dollars for selling the same number of units at a lower overall selling price, but your inventory costs are higher. If your company didn't write down its inventory value at the end of 2008, you may have to wait until the end of 2009. Exceptions exist for companies whose fiscal year is not based upon the calendar year.
Regardless of your timing, your company may take a hit on its inventory value and generate unexpectedly large federal and state tax bills. According to a Georgia Tech Financial Analysis lab study quoted in the Dec. 22, 2008 issue of FinancialWeek, W.W. Grainger Inc., Lake Forest, Ill., and Graybar Electric Co., St. Louis, would increase their taxes as a percentage of total assets by two percent to three percent if LIFO is repealed.
For many distributors, the amount of stock they carry in their warehouses has grown in units and dollars. Part of this growth may be due to obsolete or outdated products not being culled from inventory. Dollars were spent to acquire the products but no sales were generated from this material. Stagnant inventory never helps a distributor's financials. Many larger companies consider themselves immune to the LIFO issue because they have a LIFO reserve fund. According to www.investorwords.com, a LIFO reserve has to do with difference between the FIFO (First In First Out) inventory accounting method and the LIFO inventory accounting method. A LIFO reserve indicates how much a company's taxable income has been reduced by using the LIFO accounting method rather than the FIFO accounting method. As prices for goods and materials rise, the LIFO reserve also rises. If you haven't set a reserve, then you are in for a surprise that can change how you value your business and when you sell your business.
In late 2008, the electrical wholesaling industry witnessed commodity and product prices that climbed the highest mountain and then jumped off a cliff. When prices seemed to be increasing daily, some distributors increased their inventory values — in units and dollars — with the concern that prices would not drop. Unfortunately, the drop was precipitous. The resulting price deflation has affected the replacement cost of the inventory. This can also be the case as manufacturers reduce their into-stock pricing, as is occurring with some manufacturers. If your company does not have a LIFO reserve fund, the impact may be significant.
For owners considering selling their distributorships, most buyers will evaluate the inventory to determine what percentage and dollar value of the inventory in the warehouse is not obsolete or dead. Dead inventory is stock the prospective seller has not sold within the same year, and that the prospective buyer hasn't sold the same year. Hence, it has no value to either party. Many distributors delude themselves into believing their inventory is more valuable than it actually is. Those that know their inventory intimately and value it realistically will maximize their sale price.
In addition, the prospective buyer will look at what method you use to value your inventory. If you have used LIFO to value your inventory, then the buyer might determine the average inventory cost and deduct the difference from their offer.
As distributors file their taxes and consider their business valuations, the question becomes, “What is my business really worth?” Overestimating inventory value without considering the impact of LIFO provisioning can alter your value, as some distributors are finding out right now. If your inventory is not turning as frequently as it did in the past, the value of this stock may be increasing unless you are reducing your ordering points. Otherwise, you may suffer from the LIFO situation described here. Your LIFO “tax holiday” could be considered an interest-free loan on your inventory. To add insult to injury, a tax bill will eventually come due. Many distributors may then consider changing their inventory valuation methodology to average-cost valuation. According to one distributor, “I tried to get an inventory loan at my bank and my banker talked to my accountant and made a 50 percent loan to my inventory value. That pretty well wiped out my LIFO value.”
Many distributors might say, “We'll just have to burn through the current inventory and take the hit.” As one eight-branch distributor said, “We decided to write our inventory down with our last physical inventory in December 2008 and converted to ‘average costing.’ We avoided some taxes, but still sustained the overall write-down on the business value. What an eye opener that was. We're rolling along thinking that we were worth $XXX million, and now we are worth almost $3 million less.”
Another distributor said, “Price deflation coupled with banks having a problem with our inventory dollar value caused us to postpone our accounting method change till next year. The book value of our company dropped about 26 percent in a 90-day period. That made us sit up and take notice. At first I couldn't believe it. But there it was in black-and-white.”
There is a potential bright spot. This is an opportunity to get your inventory as lean as possible — “rightsizing” it for today's marketplace. Frequently what and how much you are now selling differs from what you sold six months ago. If a distributor decides to write down the value of their inventory, it's a good time to get rid of dead inventory. You may want to consider donating some of it to help at tax time. You may also want to decrease fill rates or rethink service levels that require ordering more frequently or sourcing “C” or “D” items from other distributors or manufacturers' regional warehouses, or forgo that portion of the order.
In this economy, many distributors are suffering from decreased cash flow and deflation. To manage through the recession consider the following:
Prepare for changes in the way you account for inventory value
If you use LIFO, talk to your accountant/ tax advisor about a reserve fund.
Review your inventory and purge slow or non-moving items
Donate where you can. A tax write -off is better than zero value.
Reevaluate how, what and where you purchase
Chances are you can get by with less inventory. Seek to increase your turns.
Collect your days' sales outstanding (DSOs)
That inventory may have been purchased at a higher cost than the replacement material.
Allen Ray is principal of Allen Ray Associates, a consulting firm that helps companies improve profitability through effective pricing strategies and streamlining business processes through effective e-business utilization. He can be reached at (817) 704-0068 or email@example.com. David Gordon is a principal of Channel Marketing Group, a consulting firm that develops market share and growth strategies for manufacturers and distributors. He can be reached at (919) 488- 8635 or firstname.lastname@example.org. Visit their industry blog at www.electricaltrends.com for more insights into growing your business profitably.
First-In, First-Out (FIFO)
This method assumes that the oldest inventory is sold first and generally increases the value of your inventory and thus the sales prices. Many feel that FIFO gives a better indication of inventory value at the end of an accounting period of time. There generally is a much larger tax burden with FIFO and a larger inventory value.
Last-In, First Out (LIFO)
This method assumes that the last (latest) inventory unit is sold first. In a price inflation type of market, the older inventory is revalued to current cost. But because the oldest inventory was bought at a lesser amount, you would pay less tax on it than you would in an economic scenario with an inflationary rise in prices. Generally your inventory has less book value.
A LIFO reserve indicates how much a company's taxable income has been reduced by using the LIFO accounting method rather than the FIFO accounting method. As prices for goods and materials rise, the LIFO reserve will also rise.
This method uses a weighted average of all units available for sale at the end of an accounting period to determine a cost of goods sold. The Average Cost method produces an inventory value that is somewhere between LIFO and FIFO.
Note: These are general descriptions of accounting methods. Consult your CPA for financial guidance.