Quick answer: Inventory due diligence tests whether the stock on the balance sheet exists, belongs to the company, is costed correctly and can be sold for at least its carrying value. Buyers observe or reconcile a physical count, roll it forward to the closing date, test costing and capitalized overhead, and measure reserves for slow-moving and obsolete items. A shortfall lowers adjusted EBITDA, working capital or both.
Key points
- Buyers test inventory for existence, ownership, cost and saleability, and each test produces a different kind of adjustment.
- A physical count proves little without a roll-forward, which reconciles the count date to the balance sheet date using receipts, shipments and production records.
- Costing policy and capitalized overhead decide how much cost sits on the balance sheet and how much reaches the income statement, so a build in stock can flatter earnings.
- A reserve that is too low lowers earnings in the periods that should have carried the charge and lowers the inventory counted in working capital at closing.
Four tests for the stock on the balance sheet
Inventory is where the income statement and the balance sheet meet. Every dollar of cost left in inventory is a dollar that has not yet reached cost of goods sold, so an overstated balance means overstated profit. Buyers test four things. The stock must exist, the company must own it, it must be carried at the right cost, and it must be saleable for at least that cost. SBA’s guide to buying an existing business lists inventory among the areas that due diligence covers, alongside contracts, leases and cash flow.[1] The diligence overview shows where this work sits in the wider financial review.
| Test | What the buyer does | Records requested | Where a finding lands |
|---|---|---|---|
| Existence | Observes or repeats a physical count, tracing floor to count sheet and sheet to floor | Count instructions, tags and sheets, cycle-count history | A book-to-physical adjustment, one-time or recurring shrink |
| Roll-forward | Carries the count to the balance sheet date using receipts, shipments and production | Receiving and shipping logs, production records | A corrected balance, with unexplained gaps treated as shrink |
| Ownership | Confirms stock held by third parties, stock in transit and consigned goods | Warehouse confirmations, consignment agreements, shipping terms | Goods removed from or added to the balance |
| Cost | Traces unit costs to vendor invoices, standard cost files and overhead rates | Bills of materials, routings, variance reports, overhead calculations | Adjusted margin and EBITDA |
| Saleability | Ages the stock, compares the reserve with a method and checks later sales prices | Aging report, usage history, reserve calculation, scrap and disposal records | Reserve shortfall in EBITDA and working capital |
| Margin trend | Sets gross margin against inventory growth by product and month | Monthly cost of goods sold and inventory by product line | Questions that send the team back to cost and cut-off |
Counts and the roll-forward to closing
Some companies run perpetual systems and test them with cycle counts. Others count the whole stock once a year and estimate the balance in between from margin percentages. An estimate is only as good as the last count, so where the last full count was at year-end and closing is months later, the closing balance is a guess unless someone counts near the closing date.
At a count, the buyer’s accountants pick items from the floor and trace them to the count sheets, then pick lines from the sheets and find them on the floor. They check that tags are controlled and that goods received or shipped during the count are cut off correctly. A roll-forward then starts from the counted quantity and cost, adds receipts and production, subtracts shipments and usage through the balance sheet date, and compares the result with the books.
Because the closing balance feeds the working capital adjustment, the purchase agreement usually fixes who counts, on what date and how disputes are settled. Agreeing that procedure early avoids an argument over a count that neither side watched. The working capital peg guide shows how the closing figure is compared with the target.
Costing and capitalized overhead
Buyers check unit cost in two parts. For purchased goods they trace cost to vendor invoices, adding the freight and duties the company capitalizes. For made goods the cost includes materials, labor and a share of manufacturing overhead, and many manufacturers carry stock at a standard cost and book the gap from actual cost as variances. The buyer asks how often standards are updated and where variances sit at period end.
Overhead absorption is where earnings can move without a sale. When a company builds stock ahead of demand, more fixed overhead is absorbed into inventory and less reaches cost of goods sold, which lifts margin and EBITDA until the stock sells or is written down. Buyers recompute absorption under a consistent policy and set gross margin against inventory growth. Rising material prices flatter margin differently, because goods bought at old costs and sold at new prices show a margin the company will lose once it replaces stock at current cost. The guide to inventory adjustments to earnings covers the earnings side in detail.
Reserves for slow-moving and obsolete stock
Reserve methods fall into three types. Aging-based reserves apply a percentage to stock by time since last sale or use. Usage-based reserves compare the quantity on hand with expected demand and reserve the excess. Specific reserves write items down one by one after an operations review. Buyers care less about the method than about consistency and whether the booked reserve is close to what the method produces. They also check whether the reserve is ever used. If scrap and discounted sales go straight through cost of goods sold each month while the reserve never moves, it is not doing its job. Sales after the balance sheet date show the rest, since items sold below cost reveal the loss the books should have carried.
Illustrative example: A reserve shortfall reaches earnings and working capital
A distributor carries $5,000,000 of inventory at cost and a booked reserve of $100,000. The buyer’s accountants age the stock by date of last sale and apply placeholder reserve rates, which are not the rates anyone will use.
| Time since last sale | Inventory at cost | Placeholder rate | Required reserve |
|---|---|---|---|
| Recent movement | $3,200,000 | 0% | $0 |
| Slow | $1,000,000 | 10% | $100,000 |
| Very slow | $500,000 | 40% | $200,000 |
| No movement | $300,000 | 80% | $240,000 |
| Total | $5,000,000 | $540,000 |
The required reserve exceeds the booked reserve by $440,000. The same test on the balance a year earlier shows a required reserve of $400,000 against $100,000 booked, a shortfall of $300,000, so the shortfall grew by $140,000 during the year. That $140,000 is the charge that should have reduced the year’s earnings, and at an invented multiple of 6.0x it lowers the price by $840,000.
The other $300,000 belongs to earlier years and does not lower this year’s EBITDA, but the inventory balance is overstated by the full $440,000. If the working capital target of $4,100,000 was built from months that carried the old reserve, and closing working capital is measured with the buyer’s reserve, the closing payment falls by $440,000. Restating the target on the same method largely removes that second reduction. The numbers, rates and target are invented to show the mechanics and are not benchmarks.
Consigned goods, other locations and shrink
Ownership is not the same as location. Goods the company holds for a customer or vendor on consignment are not the company’s and belong outside inventory. Goods the company has placed with a distributor on consignment remain its own until the distributor sells them, which also means revenue should not have been recorded at shipment. Stock in third-party warehouses and in transit is confirmed in writing, and the buyer reads the shipping terms to see who owned the goods at period end.
Shrink is the loss between book and physical quantities from theft, damage, spoilage and miscounts. Buyers chart the adjustment after each count. A steady modest amount is a cost of doing business and stays in normalized margin. A large adjustment in one count may be a one-time event the seller can support, such as a flood or a system change, or it may show years of unrecorded loss that the buyer pushes back into earlier periods.
From inventory findings to price, and what a seller can do first
Findings travel three routes. The first is earnings: overhead absorbed into a stock build, reserve shortfalls and recurring shrink reduce adjusted EBITDA, and the multiple magnifies the change, as the guide to quality of earnings findings shows across all areas. The second is working capital, since inventory is often a large part of the target and every dollar of write-down lowers the closing figure measured against it. The third is structure, such as an agreed closing count, an escrow for a disputed block of stock or a list of items the buyer will not pay for. Industry guides, such as those for building products distributors and furniture manufacturers, add tests specific to supplier rebates and tariff exposure.
Sellers can prepare before the buyer arrives.
- Count and reconcile. Run a full physical count under written instructions and reconcile it to the ledger.
- Write down the policy. Document the costing method, overhead rates, standard cost updates and reserve method, and apply them the same way every month.
- Deal with dead stock. Sell, scrap or reserve it on a documented basis before the buyer ages it, with the CPA’s input on timing.
- Map ownership. List consigned goods, third-party locations and goods in transit, with the agreement behind each.
- Plan the closing count. Propose who counts, on what date and how a dispute is resolved before the buyer does.
Frequently asked questions
Do buyers count inventory themselves?
Often they observe or repeat part of the seller’s count. The accountants pick items from the floor and trace them to the count sheets, then pick lines from the sheets and find them on the floor. Where the last full count was long before closing, the purchase agreement usually calls for a count near the closing date with both sides present.
What is an inventory roll-forward?
It is a reconciliation that carries a counted balance to a different date. The accountants start from the quantity and cost counted, add receipts and production, subtract shipments and usage, and compare the result with the books at the balance sheet date. Unexplained differences are treated as shrink or error.
How does inventory affect the working capital peg?
Inventory is part of net working capital, so its carrying value moves both the target and the closing figure. The reserve method used to set the target should match the method used at closing. If the buyer applies a stricter reserve only at closing, the seller delivers less working capital than the target assumed and the price falls.
Should a seller write down slow-moving inventory before going to market?
Often it is better to resolve it before a buyer ages the stock, by selling it, scrapping it or reserving it on a documented method. A write-down inside the period being priced lowers reported EBITDA, and a buyer may or may not treat it as a one-time item, so timing and treatment are questions for the company’s CPA.
How are consigned goods treated in a sale?
Goods held for others on consignment are not the company’s and belong outside inventory. Goods the company has placed on consignment with a customer or distributor remain its inventory until sold, and revenue should not be recorded at shipment. Buyers ask for the consignment agreements and written confirmations of stock at third-party locations.
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Related guides
- Net Working Capital Peg: How the Working Capital Adjustment Works: The working capital peg sets the level of working capital a seller must leave in the business at closing. See how it is calculated, negotiated and adjusted.
- Inventory Adjustments to EBITDA: Costing, Reserves and Capitalized Overhead: How inventory costing, standard cost variances, capitalized overhead, reserves, count differences and cut-off change EBITDA in a sale, and how buyers restate them.
- Quality of Earnings Report: What It Is and What Buyers Test: A quality of earnings report tests whether a company’s reported profit is real and repeatable. See what buyers examine, how it affects price and how sellers prepare.
- Quality of Earnings Findings That Reduce Price and How to Pre-Empt Them: The quality of earnings findings that most often lower a sale price, such as rejected add-backs and cut-off errors, with how each appears and how to pre-empt it.
- Sell-Side Quality of Earnings Report: Scope, Timing and How to Use It: What a sell-side quality of earnings report covers, when an owner should commission it, who should perform it and how to use it in the CIM and with buyers.
- Managing the Diligence Process as a Seller: Request Lists, Q&A and Response Discipline: How a seller runs due diligence: one point of contact, a request tracker, staged disclosure, a Q&A log and response discipline while the business keeps performing.
Sources
- Buy an existing business or franchise. U.S. Small Business Administration. Accessed October 13, 2026.
This guide is general education. It is not a valuation opinion, appraisal, investment advice, or legal or tax advice. How these guides are made.