Pharmacy U presenters Mike Jaczko & Max Beairsto: Fix these accounting mistakes in 2023, Part 1: Inventory
With a few weeks already gone by in the new year, we’ve probably all had time to break a few resolutions already. Those veggies we pledged to eat every day just don’t taste right. That gym we signed up for is simply too far away. And yeah, it turns out we really like French fries. But rather than feel bad about breaking your New Year’s promises, why not just come up with some new resolutions? For all you pharmacist-owners out there thinking of selling your business, we have a really good resolution: fix your accounting!
Bad accounting practices are just, well, bad – for your business and for its value when it comes time to sell. If your books are unreliable, a potential buyer is going to look askance at your pharmacy and wonder what else is wrong, which means they won’t be as willing to pay top dollar for it. Also, time kills deals, and shoddy bookkeeping usually takes time to fix. So, if you leave fixing it till the last minute, you may end up with a delayed or dead sale transaction on your hands.
Where to begin?
In our experience, one of the most common areas where bad accounting impacts a sale process is inventory. Potential buyers are keenly interested in the value of the stuff you have at your pharmacy, because it directly affects its value. And if your books don’t give an accurate picture of inventory, it can be a big red flag for a buyer.
Unfortunately, we see pharmacist-owners make inventory accounting mistakes quite often. Here are three you should resolve to correct in 2023:
- You don’t do a physical count of inventory and simply guess at its value.
Physically counting inventory is a drag on time and resources, yet it is absolutely imperative that you do it. Only with a firm and realistic grasp of your inventory’s net value (what you paid for it minus your commercial terms) can you develop a reliable number for your cost-of-goods account, or COG, which in turn is vital to calculating your store’s profitability (typically expressed as EBITDA, for earning before interest, taxes, depreciation and amortization). Guessing at inventory value is putting garbage in, and then getting garbage out. Potential buyers won’t be able to figure out what your business is actually worth, and many will just walk away
- You manipulate inventory count to get a “corrected” margin.
This is just plain wrong, ethically and probably legally. But we have seen it happen: a pharmacist-owner or that person's accountant will inflate or deflate the inventory count to come up with some “target” profitability for the pharmacy. From a numbers perspective, this creates the same problem for potential buyers as Mistake No. 1 above: they have no idea of the pharmacy’s real value. But in some ways, it’s even worse, because playing with the inventory data to come up with a phoney EBITDA suggests malfeasance on the part of the pharmacist-owner. A buyer will wonder what else about your pharmacy – or about you – is untrustworthy and unreliable. At best, that will lower the price they are willing to pay; at worst, it will scupper the deal.
- Ballooning or deflating inventory to lower or raise COG.
This is just a more granular version of Mistake No. 2 above, when a pharmacist-owner or their accountant plays with inventory counts to achieve a target COG (and therefore target profitability). We have seen this most often when the pharmacist-owner or accountant wants to make sure the pharmacy’s earnings come in under the threshold for small business taxation. But the reason doesn’t really matter in the eyes of a potential buyer, who will have less trust in you and assign less value to your pharmacy.
OK, so let’s set aside the moral arguments against these “accounting practices” (we use the term advisedly) and talk about their practical impact through a hypothetical example of what can go wrong when a pharmacist-owner makes the least egregious of these three accounting mistakes: not doing a physical inventory count:
Our hypothetical owner is thinking of selling, but hasn't performed a physical inventory in a long time. On the books, they have what they think is a pretty good estimate of net inventory value, but when we get called in as transaction advisors, it’s clear that no buyer in their right mind would consider the estimate reliable. To fix it, the pharmacist-owner has to perform physical count. That takes time. (Remember: time kills deals.) Then, they have to wait six months and do it again, to give us a second point of reference. Based on those data, we can estimate the turns of inventory (how long it takes the pharmacy to sell stuff in the dispensary and front-of-store) to come up with an idea of margins and reconstruct the pharmacy’s balance sheet going back five years. That reconstruction will be far, far better than the original guesstimate. But it will still be just a guess.
And it might not be good enough for a buyer. Because the margin calculation is a guess, they will probably apply a lower multiple to value the business, which means they will be willing to pay less for it than they would have if profitability had been based on years of physical inventory counts. There’s another cost, too – in time. During those six months-plus when the pharmacist-owner has to delay selling to perform physical inventory counts, a lot about the business might change: key staff could leave, new competitors could spring up, new regulations could come into force, and on and on. Any of those things could affect your pharmacy’s value, and probably not in a good way.
If you are considering selling your pharmacy, there is no better way to get in the “good books” of potential buyers than to keep “good books.” Pharmacist-owners can pay a high price for inventory accounting mistakes when it comes time to sell. Our advice: if you’re committing these errors, resolve to fix them. The sooner, the better. This is one resolution you should definitely keep.
