For a product, distribution, or manufacturing business, inventory is often the largest single item on the balance sheet and one of the most heavily tested during a sale. Buyers and their diligence teams treat inventory as a proxy for how carefully the company keeps its books, because the value carried in the ledger depends on estimates, counting discipline, and consistent accounting policy. When those estimates prove optimistic, the finding tends to reduce reported earnings, working capital, or both. This article explains, at a general and educational level, how inventory is examined in a lower middle market transaction. It is not accounting, tax, or legal advice, and the treatment of any specific company depends on its facts and the professionals it engages.
Why inventory draws scrutiny in a sale
Under U.S. GAAP, inventory is generally carried at the lower of cost or net realizable value. That standard invites judgment, since a company decides what its goods can realistically be sold for after any costs to complete and dispose of them. A quality of earnings review, the buy-side or sell-side analysis that normalizes historical earnings, frequently lands on inventory because the account touches both the income statement, through cost of goods sold, and the balance sheet, through the asset value that feeds working capital. Reviewers often warn against focusing only on EBITDA adjustments while ignoring the quality of assets such as slow moving inventory. Overstated inventory can inflate both reported profit and the assets a buyer is paying for.
Obsolete and slow-moving inventory reserves
Excess, obsolete, and slow moving stock, sometimes abbreviated E&O, is a recurring diligence finding. The central question is whether the company has recorded an adequate reserve against goods that are unlikely to sell at full value. A common reserve framework treats items with no usage over a multi-year window as obsolete and reserves them fully, while items on hand in quantities that exceed a multi-year supply receive a partial or full reserve based on expected usage. Because holding stock over long periods erodes its realizable value, reserve estimates are meant to reflect the time value and the risk of markdown.
Typical diligence flags in this area include:
- Aging that thins out reserves. A large tail of items that have not moved in years, paired with a small reserve, suggests the balance is overstated.
- Reserves released just before a sale. Reducing the reserve lifts reported assets and earnings, a pattern reviewers watch for.
- Physical condition issues. Damaged, expired, or superseded goods that still sit at full cost in the ledger.
An E&O writedown identified in diligence often becomes an EBITDA normalization, a working capital adjustment, or a negotiating point on price.
Costing methods and why consistency matters
The value assigned to a unit of inventory depends on the costing method. The main approaches include first in first out (FIFO), which assumes the oldest costs flow to cost of goods sold first, last in first out (LIFO), which assumes the most recently acquired costs flow first, and weighted average cost. Manufacturers also choose between actual costing and standard costing, where standard costing books a predetermined cost and later reconciles variances against actual results.
Consistency is what matters most to a diligence reviewer. A company that switches methods, or applies its policy unevenly across periods or product lines, produces earnings that are hard to compare year over year. Two recurring issues surface in the lower middle market. First, some companies expense inbound freight and related landed costs rather than capitalizing them into inventory under ASC 330, which understates the balance sheet and distorts margins. Second, unreconciled standard cost variances can hide the true cost of production. Reviewers frequently normalize inventory valuation methods, for example restating LIFO figures toward FIFO, so that results are comparable across the review period.
Physical counts and cycle-count accuracy
A ledger balance is only as reliable as the count behind it. Two counting disciplines are common. A full physical count, often performed at period end, tallies everything at once. Cycle counting instead samples the warehouse continuously, counting high value or high velocity categories more often than low value ones, which reduces operational disruption while still covering the full catalog over time. Buyers tend to view a well run perpetual system with disciplined cycle counts as evidence of reliable records, though the accuracy of that system is usually verified during diligence.
In many transactions a physical count is a closing condition, and its result can flow directly into the purchase price through the working capital mechanism. Weak count accuracy, large book to physical adjustments, or an inability to reconcile the perpetual system to the general ledger are all findings that can widen a buyer estimate of risk. Distribution and manufacturing businesses with goods spread across multiple sites, consignment locations, or in transit tend to draw extra attention, since stock that is hard to observe is also hard to verify. Reviewers commonly ask for count histories and adjustment logs to gauge how far the recorded balance drifts from reality over time.
How inventory interacts with working capital and the peg
Inventory is one of the largest components of net working capital, so it sits at the center of the purchase price adjustment mechanism. In most deals the parties set a working capital target, commonly called the peg, that the seller is expected to deliver at closing so the business can operate normally on day one. The peg is typically built from a trailing average of normalized working capital, often over a trailing twelve month period in middle market deals, adjusted for seasonality and one time items.
After closing, the parties true up the actual delivered working capital against the peg, generally within a window of roughly 60 to 120 days once receivables are collected and accounts are finalized. The adjustment runs dollar for dollar. If delivered working capital exceeds the peg, the buyer pays the difference, and if it falls short, the seller does. Inventory is a frequent source of disputes in this process. A seller that trims reserves or lets stock run down before closing can inflate delivered working capital, only to face a downward true up when the buyer must reinvest to reach normal operating levels.
LIFO reserve and tax in an asset versus stock sale
Companies that elect LIFO for tax purposes build up a LIFO reserve, the accumulated difference between inventory valued under LIFO and the higher figure it would carry under FIFO during periods of rising costs. That reserve represents income that has been deferred, and its treatment on a sale depends heavily on structure. The following is a high level summary and not tax advice.
- Asset sale. Selling the assets generally triggers recapture, so the accumulated LIFO reserve tends to be recognized as ordinary income in the year of sale.
- Stock sale. When the corporate shares change hands, there is usually no sale of the LIFO inventory itself, so the deferred liability generally travels with the entity rather than being recognized at closing. Buyers often account for that embedded future liability in how they value the stock.
Other events can also trigger recapture, including certain conversions from a C corporation to an S corporation and some mergers. Because LIFO carries a book conformity requirement under the tax rules, the method also affects reported financial results, which can matter for loan covenants and comparability. The interaction of structure, entity type, and inventory method is fact specific, and companies typically model these outcomes with qualified tax counsel before signing.
Preparing inventory records before a process
Much of the friction inventory creates in diligence traces back to records that were never built for outside scrutiny. Reserves that reflect current aging, a costing policy applied consistently and documented, reconciled cost variances, and a perpetual system that ties to the general ledger all tend to shorten the diligence cycle and reduce surprises at the true up. A prepared sale process, whether run by an advisor, an investment bank, or a platform such as Bankerly, generally surfaces these items early so they can be addressed on the seller timeline rather than under deadline pressure. The general point is that inventory quality is testable well before a buyer arrives, and stronger records tend to translate into fewer late stage adjustments.
Sources
- LBMC - Inventory Due Diligence in Manufacturing M&A
- Valutico - Quality of Earnings (QoE) Adjustments: A Guide for M&A Deals
- The Tax Adviser (AICPA) - Why LIFO, Why Now?
- Schneider Downs - Understanding the Net Working Capital Peg in M&A Transactions
- Morgan & Westfield - Net Working Capital (NWC) for M&A: A Complete Guide
Frequently asked questions
- What is an inventory reserve and why do buyers care about it?
- An inventory reserve is a contra-asset that reduces the carrying value of goods unlikely to sell at full price, such as obsolete, damaged, or slow moving stock. Buyers care because an inadequate reserve overstates both assets and reported earnings, so a quality of earnings review often tests whether the reserve reflects current aging and realizable value.
- How do FIFO, LIFO, and average costing differ?
- FIFO assumes the oldest inventory costs flow to cost of goods sold first, LIFO assumes the most recently acquired costs flow first, and weighted average blends all costs. During periods of rising costs, LIFO generally reports higher cost of goods sold and lower taxable income than FIFO. Diligence reviewers weigh consistency of application at least as heavily as the method chosen.
- How does inventory affect the working capital peg?
- Inventory is usually one of the largest components of net working capital, which is measured against an agreed target called the peg. After closing, actual delivered working capital is trued up against the peg on a dollar for dollar basis, typically within about 60 to 120 days, so understated reserves or run down stock at closing can produce a downward adjustment.
- What happens to the LIFO reserve in an asset sale versus a stock sale?
- In an asset sale, the accumulated LIFO reserve generally recaptures as ordinary income in the year of sale. In a stock sale, the inventory itself is not sold, so the deferred liability generally stays with the entity and travels to the buyer, who often reflects it in how the stock is valued. Outcomes are fact specific and warrant qualified tax advice.
- Why do physical counts and cycle counts matter in diligence?
- A ledger balance is only reliable if a disciplined count supports it. Full physical counts tally everything at period end, while cycle counting samples the warehouse continuously and counts high value categories more often. Large book to physical adjustments or a perpetual system that will not reconcile to the general ledger are common red flags that raise a buyer estimate of risk.
Considering a sale in the next few years? See what a prepared process looks like.
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