Many manufacturers manipulate their inventory in an effort to lower taxes. It’s a common practice. However, using inventory to lower taxes will hurt the sale of your manufacturing company.
With the 2021 tax season upon us, manufacturers considering the sale of their companies this year are working with their tax professionals to finalize their year-end financials and tax returns. However, if you do what you’ve always done, you could be shooting yourself in the foot.
Consider the Following Before you Smooth Your Inventory to Avoid a Large Tax Bill
Lower middle-market manufacturing companies are typically sold at a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), or SDE (Seller Discretionary Earnings). These are both calculated by starting with your NET INCOME and making the appropriate add backs. These multiples are currently ranging from 3-7x, depending on the size of the manufacturing company. Many factors play into the multiple applied to a particular business and you can read more about that here.
Using Inventory to Lower Your Net Earnings, and Thus Your Taxes
This technique of using inventory to lower your net earnings lowers the number the multiple is applied to, thus lowering the value of your company.
Check out the following examples:
The below chart illustrates an example where the company starts with net earnings of $750,000,
and with appropriate add backs has a total SDE of $1,320,000.
With a 5x multiple applied, the value of this company would be $6.6 million.
Below shows the same company with $100,000 shaved off the net earnings as a result of
“inventory smoothing”:
Notice that the company lost $500K in value. Assuming a tax rate of 21%, the owner saved $21K on the $100,000 reduction in net income. This tax-saving practice resulted in a net loss of value of $479,000.
Neither acquisition loan underwriters nor quality buyers will accept “inventory smoothing” as an add back. You’ll lose that value.
Here’s something else to consider. Manufacturing companies with higher EBITDA or SDE numbers sell at higher prices because there is simply more competition for the acquisition.
The bottom line: Using Inventory to Lower Taxes Will Hurt the Sale of Your Manufacturing Company.