Inventory Central to Retail M&A Due Diligence – Part II

In part one of this three-piece series, we discussed the risks associated with inventory purchased as part of the acquisition of a retailer and the importance of performing accurate and complete due diligence on the Target company’s inventory operations and financial position to mitigate those risks. This post will discuss the specific tasks and procedures a Buyer should contemplate performing on the Target’s inventory prior to closing the M&A transaction.

In order to properly evaluate inventory of the Target, it is important for the Buyer to understand the perpetual or other electronic inventory system maintained by the Target. The Buyer should have a full understanding of how items are entered into and removed from the perpetual inventory system. The Buyer should also determine the frequency of physical counts of the inventory, the date of the last physical and evaluate any book to physical adjustments recorded as a result of the counts. In addition, the Buyer should perform test counts on a representative sample of inventory, based on the latest perpetual inventory report. If variances appear unreasonable, then the sample size counted should be increased since the sample should be sufficient for the Buyer to be satisfied that the balances reported are accurate.

The inventory test counts and other due diligence of inventory should focus on identifying whether there is any evidence of the following:
  • Slow or obsolete inventory
  • Damaged inventory
  • Consigned inventory
  • Bill & Hold inventory
If so, the Buyer should ensure that it performs adequate due diligence to ensure it fully understands whether these items impact the recorded value of the inventory.

Other common due diligence procedures performed to evaluate inventory include:

1)      Conversations with the Target’s management and inventory personnel to ensure that the Target has adequate safeguards against inventory theft;

2)      Calculating inventory turnover, which will provide a Buyer with an estimate of how many times during a certain period the Target’s inventory must be fully replenished;

3)      Performing inventory cost testing in order to verify, on a sample basis, that the items included in inventory were properly costed;

4)      Performing a gross profit test on a representative sample of inventory items sold to determine the accuracy of the cost of goods sold; and

5)      Carefully evaluating inventory reserves and assessing the adequacy of those reserves.

Mitigating the risks of purchasing unsalable, obsolete, damaged or slow moving inventory is key in any retail M&A transaction. Failing to perform sufficient due diligence on the inventory purchased can lead to costly and time consuming post-acquisition disputes.

Stay tuned for next month’s blog to discuss issues in purchasing inventory of bankrupt retailers.

Have you been involved in any post-acquisition disputes over inventory?