Most aerospace and defense companies have inventory. In some cases, A&D distributors will simply buy goods, mark them up and resell them. In more complex situations, like manufacturing, A&D companies will buy parts and materials, add labor and processes, and convert them into finished goods. From an accounting perspective, these are referred to as Raw Material, Work In Process and Finished Goods inventories.
All types of inventory share one characteristic: they tie up cash, which can impact cash flow and detract from the value of the company. Most buyers will track and compare company’s Days of Inventory (inventory on balance sheet, divided by Cost of Goods Sold, divided by the revenue period) as a measure of how well the company is managing its inventory (compared to history and to its peers) and how much cash is being consumed by inventory.
The need for A&D companies to hold inventory inevitably raises the question of “how much is optimal?” Over the past few decades, we have seen in our practice the implementation of Lean Manufacturing and the adoption of advanced inventory optimization tools (such as Kanban or Min/Max). While these tools can dramatically reduce cash investment in inventory and improve free cash flow, they simultaneously increase A&D companies’ exposure to the risk of stockouts which became commonplace during recent COVID-related supply chain disruptions. Shipment of many mission-critical systems were held up for want of one or a few small but critical components. Such recent experiences caused many A&D companies to reassess their inventory policies and increase their buffer stocks to protect their ability to deliver products during periods of supply disruption.
For owners of middle-market A&D companies who are considering selling their companies, the topic of Days inventory raises several issues directly tied to the value of the business:
- Can the company reasonably defend its inventory practices and show buyers that they have achieved the optimal balance between conserving cash and protecting against stockouts? If not, buyers will make their own adjustments when calculating future cash flows?
- Do the inventory accounting policies (charges for obsolescence and/or excess) comply with Generally Accepted Accounting Principles?
- Has the Company’s Days Inventory been stable or fluctuating? If fluctuating, why? How does the company’s Days Inventory compare to its peers?
In summary, inventory can have a material impact on the value of a middle market A&D company. Accordingly, sellers should expect to buyers to conduct deep diligence on Days Inventory.
Have a great day everyone.