Cost of Goods Sold Based on Historical Trends
It is common to see a Discounted Cash Flow in a business valuation report. There are a lot of companies that sell or manufacture a product. These types of companies are supposed to account for the inventory needed to sell their product. Exhibit 1 below is an old set of financial data taken from a company’s federal income tax returns, prepared by a CPA. The summary indicates a 68.3% average cost of goods percentage and an average gross profit percentage of 31.7%, they not accounting for changes in inventory on the tax returns.
As a result of not accounting for the change in inventory that should have been on the tax returns, the Gross Profit is overstated which indicates that the company is more profitable than it actually is.
Cost of Goods Sold With Inventory
To calculate the Cost of Goods correctly you start with the inventory at the beginning of the year, add the purchases to arrive at the goods available to be sold and subtract the inventory at the end of the year to determine the cost of goods sold or the cost it took to sell the product. This requires that management maintain a system of accounting for the inventory
Neither the beginning nor the ending inventory was not included on the tax returns but some of the inventory items were included in the financial statements.
Normalizing the Cost of Goods in a business valuation is a normal process and is accomplished by adjusting the Cost of Goods Sold by the inventory makes a significant impact on the changing amounts and percentages. Comparing Exhibit 1 and 2 provides valuable information needed to make a forecast of the Cost of Goods Sold and Gross Profit.
Without being thorough and requesting supporting evidence the forecast of these expenses, relying on tax returns, signed under perjury, would have been materially incorrect. There was still missing information but, using the information above, it can be seen that the average cost of goods sold would decrease by approximately 47% and the normalized gross profit would increase by approximately 101%. This is a dramatic change in the information used for forecasting. The following table shows the changes in Cost of Goods Sold and Gross Profit.
Why should the attorney care?
The business valuation or damages expert has not performed the work correctly.
The business valuation or damages expert may not have relied on sufficient facts or data.
The business valuation or damages expert may not have relied on generally recognized principles and methods to perform the work product.
The business valuation or damages expert has determined an incorrect value or damage claim for the company.
The incorrect value may be to the detriment of your client.
If the client is not informed of these issues and they are not corrected and the client learns of this at a later date, the client could potentially harm your reputation.
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Richard Claywell has been valuing closely held companies since 1985. He has earned two of the highest designations in the business valuation field , the Certified Business Appraiser (“CBA”) and Accredited Senior Appraiser (“ASA”), Richard is a Certified Public Accountant, has a Master’s in Business Valuation and holds the ASA, CBA, ABV, ICVS, CVA, MAFF, CFD, CVGA, ICVS-A credentials.