In a business that sells goods, cost of goods sold is calculated as opening inventory plus purchases, less closing inventory. That formula makes the year-end inventory figure a direct input to gross margin. Every dollar of overstated closing inventory is a dollar of overstated EBITDA, and at a 5x multiple it becomes five dollars of purchase price. Over a period, EBITDA moves with the change in inventory through COGS; at close, the level of inventory (net of reserves) hits the working-capital true-up. That is why a Quality of Earnings review in a distribution or manufacturing business tests inventory as an earnings item as well as a balance sheet account. In owner-run businesses, the controls around it are usually the weakest in the finance function. Where Inventory Distorts Earnings - Physical counts only at year-end: Many businesses use a periodic inventory system, where stock is physically counted only at year end. Cost of sales during the year is booked at an estimated margin, and the count corrects it in one entry. A trailing twelve-month period that ends mid-year has none of that count-based correction, so interim margins often run higher than any margin the business has achieved at a count. - Slow-moving stock carried at cost: Items that have not sold in a year or more often stay on the books at full cost. An obsolescence reserve writes that stock down to what it can realistically sell for. The QoE estimates the reserve the business should have held at each balance sheet date in the review period, using the inventory aging at each date. Any incremental reserve required, had the policy been applied consistently, is treated as an earnings adjustment in that period; the cumulative reserve is deducted from inventory when calculating the working-capital peg. - Cut-Off: Goods received and counted before year end, with the supplier invoice posted in the following period, raise closing inventory without a matching purchase. The result is a double benefit: lower COGS this year and higher inventory on the balance sheet, both of which flow through to higher EBITDA and a higher working-capital unless corrected. Gross margin is overstated by the full value of those goods. - Capitalized Overheads: A manufacturer allocates fixed plant overhead, such as factory rent and supervision, to every unit it produces. The unsold units carry part of that capitalized overhead in closing inventory instead of cost of sales, and reported margin rises with no change in demand. In a low-volume period, more overhead sits in inventory; in a high-volume period, more flows through COGS. That can make EBITDA look better when production is out of line with sales. How It Reaches The Working Capital Peg The working capital peg is the level of working capital the seller agrees to deliver at close, usually set from a historical monthly average. If closing working capital falls short of the peg, the price is reduced by the shortfall. In these businesses, inventory is a significant part of the peg. The obsolescence reserve is deducted from inventory when calculating net working capital for the peg; aged or obsolete stock that would not receive full credit in a diligence review should be reflected in that reserve. Considerations For Both Sides 1. Buyers: - Request inventory aging by item at each balance sheet date in the review period. - Roll the last count forward to a date close to signing. - Confirm inventory valuation methods and cost layers have been applied consistently across the review period; any changes are flagged as potential manipulation signals. 2. Sellers: - Run a full count and an obsolescence review before going to market. - Monthly or cycle counts in the twelve months before a sale give the buyer evidence for interim gross margins. - Ensure the same valuation policy and reserve methodology are used in the CIM, management accounts, and year-end financials. Share Your Perspective: Has a count or an obsolescence review reshaped a recent deal? Reply and share how the gap was resolved.