Our memories of the pandemic are fading rapidly. However, sellers are still dealing with the lingering effects of supply chain issues and larger-than-normal inventory levels. We all remember when businesses were coping with shortages related to factory shutdowns in China, shipping delays, and skyrocketing freight costs. While, for the most part, these issues are behind us, they have left an impression on the financial statements of businesses.
The issue at hand is that the years of the pandemic do not accurately reflect the performance of the business on a normalized basis. Furthermore, many companies still carry inventories they bought at the tail end of the supply chain debacle. This is because most companies overbought to meet customer needs. We regularly deal with this in the Quality of Earnings (QofE) reports we issue. In this post, I want to discuss how we normalize inventory and freight costs. Naturally, one must deal with revenue related to the “covid bump,” but that’s another article.
Getting down to brass tacks, these are the issues one has to grapple with:
1. While calculating Net Working Capital (NWC), what is the correct amount to include in inventory?
The decision to stock up on inventory could hurt sellers, especially if they maintained the payment terms with the vendors. This would result in the ballooning of NWC. In most transactions, the buyer wants the seller to leave an agreed-upon amount in NWC at closing. This amount is typically calculated as an average NWC number over the trailing twelve months (TTM) before closing. If the NWC grew because of the supply chain issues, the average over the TTM period also increased. If nothing is done, the seller will leave money on the table in the form of higher NWC.
Here is a straightforward solution we will deploy to solve this. All things being equal, inventory turns reflect how much inventory a business carries on a normal level. Logic dictates that when you stock up inventory to satisfy needs for six months rather than three, inventory turns will slow down. We look at inventory turns pre-covid when the world was “normal” and compare that to the turns over the TTM period. In conversation with the management and by examining all facts, we devise a justifiable normal level of turns. We then apply that to the TTM period to normalize the inventory figures, and we have a solution, viola.
Here is a question for extra credit. What if the payment terms from the vendor got modified? Suppose the vendor agrees to give 45-day terms instead of the usual 30. In cases such as this, we calculate the ratio between inventory and AP as an additional data point to consider in our calculation of normal inventory turns.
2. How have higher freight costs distorted the carrying value of inventory?
Freight costs get capitalized into inventory, as do the related fluctuations. I saw container prices from China peak at $24,000 per container; these days, I usually see them at around $1,500 per container. Some folks have reported paying even less. Irrespective of the numbers, you get the drift. The same issue arises as described earlier. The NWC gets bloated, and the seller leaves money on the table. This is a fix we utilize.
- Step 1: Determine what normal freight cost is. For this, we use the latest freight costs incurred by the business. While they might be higher than the pre-pandemic costs, we feel that this is a conservative and defensible position.
- Step 2: Calculate the excess freight costs paid by the business. We do this by obtaining fees paid per container and substituting them with the normal freight cost. This is done monthly for the period in question.
- Step 3: Once we have determined the excess freight costs by month, we remove them from inventory.
3. How does one remove the distortion caused to earnings by higher freight costs?
One cannot ignore the distortions to earnings caused by these issues. Naturally, there is the revenue side, but that is a question for another time.
I will deal with freight first. I would add Step 4 to Section 2 above. By this time, we have already calculated the inventory turns, which is the speed at which inventory turns into costs of goods sold (COGS). The higher amount of freight will unwind itself into COGS at the rate of the actual inventory turn (not normalized). Let’s look at an example to understand how this works. Suppose the business incurred $30,000 in excess freight costs in January, and the inventory turns every 90 days. This would mean that the excess freight costs of $30,000 move into COGS within 90 days or at $10,000 per month. In this example, I would reduce COGS by 10,000 per month to normalize excess freight costs.
Now you will ask how to deal with fluctuating material costs. Well, I have provided sufficient logic above to solve that problem for yourself. I cannot give away all my trade secrets.