Many manufacturers manipulate their inventory in an effort to lower taxes. Using inventory to lower taxes will hurt the sale of your manufacturing company.
Many manufacturers manipulate their inventory in an effort to lower their taxes. It’s a common practice. However, using inventory to reduce your tax bill can also hurt the sale of your manufacturing company.
Think Before Smoothing Inventory to Reduce Your Tax Bill
With the 2021 tax season upon us, manufacturers considering selling their companies this year are working with their tax professionals to finalize year-end financial statements and tax returns.
However, if you do what you’ve always done, you could be shooting yourself in the foot.
How EBITDA and SDE Determine Business Value
Lower-middle-market manufacturing companies are typically sold using a multiple of EBITDA—earnings before interest, taxes, depreciation, and amortization—or SDE, which stands for seller’s discretionary earnings.
Both calculations begin with your net income and include the appropriate add-backs.
These multiples currently range from three to seven times earnings, depending on the size of the manufacturing company. Many factors determine the multiple applied to a particular business. You can read more about those factors here.
How Inventory Smoothing Can Lower Your Company’s Value
Using inventory to reduce your net earnings also reduces the number to which the valuation multiple is applied. As a result, lowering your taxable income can significantly lower the value of your company.
Consider the following examples.
Example 1: Valuation Based on $750,000 in Net Earnings
The chart below shows a company beginning with net earnings of $750,000. After applying the appropriate add-backs, the company has a total SDE of $1,320,000.
With a five-times multiple applied, the estimated value of the company would be $6.6 million.
Example 2: Valuation After Reducing Net Earnings by $100,000
The next chart shows the same company after $100,000 has been removed from its net earnings through “inventory smoothing.”
The company lost $500,000 in value.
Assuming a tax rate of 21%, the owner saved $21,000 in taxes by reducing net income by $100,000. However, that tax-saving practice resulted in a net loss of $479,000 in company value.
Buyers and Lenders Will Not Accept Inventory Smoothing as an Add-Back
Neither acquisition-loan underwriters nor quality buyers will accept “inventory smoothing” as an add-back. You will lose that value.
Here’s something else to consider: Manufacturing companies with higher EBITDA or SDE figures generally sell at higher prices because there is simply more competition among buyers for those acquisitions.
The Bottom Line
Using inventory to lower taxes will hurt the sale of your manufacturing company.
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