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Accounting Mistakes to Fix in 2023, Part 1: Inventory

January 19, 2023

Accounting Mistakes to Fix in 2023, Part 1 Inventory

An article by Max Beairsto of EVCOR, and Mike Jaczko of KJ Harrison

It’s that time of year again when we make promises we probably won’t keep. Lose weight. Eat more veggies. Be nicer to the in-laws. Actually use that gym membership you bought last January. All of those are noble New Year’s resolutions, and we heartily commend them. However, as business transaction advisors, we would offer a few ideas for owners who are thinking of selling their business this year (or at any time, really). And they all have to do with one of the most common gaffes we have seen pharmacist-owners make over our decades of providing business evaluation services: poor accounting.

Actually, this is a set of gaffes, and any one of them can severely undermine both the likelihood of being able to sell when you want to and the ultimate price a buyer will be prepared to pay. At the very least, shoddy accounting practices can lead to delays in the selling process, because fixing them usually takes time – and, as the saying goes, time kills deals.

In our decades of experience as pharmacy business transaction advisors, we have encountered lots of accounting mistakes that can undermine valuations or even scupper a deal – too many to discuss thoroughly in one article. So, for now, we will highlight three accounting gaffes in an area of business operations that many pharmacists don’t pay enough attention to: inventory.

How much stuff you have in inventory and what it’s worth are matters of acute interest for potential buyers, as they speak directly to business valuation. Unfortunately, poor accounting practices can quickly turn inventory into a red flag in the eyes of a buyer.

Here are the Big 3 inventory accounting mistakes that you should resolve to fix in 2023:

Guessing at your inventory instead of doing a physical count

We get it: doing a physical inventory can be a drag on time and resources. But it needs to be done. If you just estimate your inventory’s net value (what you paid for it minus your commercial terms), then your cost-of-goods (COG) account will be questionable. And since COG is an important factor in calculating your pharmacy’s profitability (typically measured as earnings before interest, taxes, depreciation and amortization, or EBITDA), fuzzy inventory accounting will be a big headache to buyers trying to figure out what your business is actually worth.

Manipulating inventory count to get a “corrected” margin

This is probably unethical and possibly illegal, and – moral considerations aside – inflating or deflating your inventory count to get to a “target” profitability for your pharmacy is getting the whole exercise ass-backwards. One is supposed to use accounting to keep track of how a business is doing; one is not supposed to decide how your business is doing and then make the numbers match. And yet we have seen it happen, with pharmacist-owners reporting “corrected” margin because they want to gussy up their financials for buyers. That usually has the opposite effect. In the language of buyers, the word “corrected” in inventory accounting often translates as “baloney,” because it suggests that COG and therefore EBITDA (margin) have been falsely manipulated (which, in this case, they probably have been). Faced with such chicanery, a potential bidder does not actually know what your pharmacy may be worth. Even worse, they will usually assume the seller is lying about it – and about other things, too.

Ballooning or deflating inventory to lower or raise COG

Similar to Gaffe No. 2 above, this occurs when an owner or their accountant decides to manipulate inventory count to reach some target cost of goods and therefore some target calculation of earnings. Often, we see this happen when a pharmacist or accountant is playing around with earnings to come in under small business tax thresholds. The effect is the same as with the other two inventory accounting mistakes: the buyer has less idea of your pharmacy’s value and less trust in you as a seller.

Why these mistakes are bad should be obvious, but just to hammer home the point, here’s a hypothetical illustration. (And believe us, this has happened in real life!).

Let’s say we get called in to provide business evaluation services for a pharmacy that had not done a physical inventory count in a long time; the pharmacist-owner is just guesstimating (Mistake No. 1). As business valuation experts, we have nothing reliable to go on, so we have to ask the pharmacist-owner to perform a physical count – which takes time, of course. Then, we estimate the turns of inventory (how long it takes to sell stuff, basically) for front-of-store and dispensary, and we reconstruct the pharmacy’s balance sheet going back five years. The result is a more accurate reflection of margin than the original accounting, but it hardly follows generally accepted accounting practices – it’s just a “best guess.”

Will that be enough for a buyer? Maybe. But even if they do accept the new numbers, they will very likely use a lower multiple in valuing the business because the margin calculation is a guess. The probable result: the pharmacist-owner gets less for the business.

There’s another cost, too: time. Add up the time needed to do a physical inventory, then the wait time to get a second reference point (you need a starting inventory count, cost of purchases, and a closing inventory count to calculate COG properly), then time for another physical inventory, and the pharmacist-owner has delayed the sale process by more than six months – during which a whole bunch of things (new drug regulations, new competition, staff turnover, and on and on) might have worked to undermine the pharmacy’s value.

So, here is the lesson: If, for whatever reason, you are making these inventory accounting mistakes, resolve to fix them. Now. Because waiting until just before you hope to sell can be very costly, indeed.

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