As a business owner, almost every action you take affects the value of your company. If you buy a new piece of equipment to increase production capacity, you might have an immediate decrease in cash value—but as you begin producing and selling more inventory, the value of your company will rise.
Measuring your company’s value is called valuation—and it can help you to secure funding, attract investors, and (eventually) sell your business for a fair price.
Valuation is an important process and can be done at a macro level for the entire business or more granularly for different business units. Valuation can also be used to track inventory and other business assets.
If you’re looking to understand valuation better, keep reading.
Why Is Valuation Important?
There are many reasons to consider a business valuation, but it’s most often tied to buying or selling a business. If you’re considering acquiring another company, you’ll want to know its value so that you avoid overpaying. Likewise, owners selling a business need to know its fair market value.
Valuation can still be important—even if you’re not in the midst of a business transaction—because it gives you additional input into how your company is performing and whether you’re moving in the right direction as a whole. Valuation can also help you to secure additional funding.
How Is Valuation Used in Inventory?
Inventory refers to physical goods made for sale, which can include manufactured products and/or raw materials. Accountants track the value of inventory at the end of the year or quarter in order to report the cost of goods sold (COGS) and gross margin.
Valuation considers the inventory on hand and its value, along with the raw materials used to create the inventory. This valuation process reflects how much the company has in stock to sell.
How Can You Calculate Inventory Value?
One of the best ways to understand the valuation of inventory is to look at the different ways it’s calculated. There are 4 key methods to valuing inventory:
- Specific Identification: Each piece of inventory has a special code and value, like an antique store recording a Victorian loveseat to be worth $500.
- First-In, First-Out (FIFO): The inventory that was brought in first will be sold first. This is important to account for inflation or temporary materials. Example: a smoothie shop will use yesterday’s bananas before they go bad instead of today’s.
- Last-In, First-Out (LIFO): The inventory that was brought in most recently will be sold first. This works for inventory that will increase in value over time—like a winery aging some barrels while selling most of this year’s production.
- Weighted Average Cost: This is an estimate used when goods are indistinguishable from one another, like a thrift shop that has 2,000 pieces of inventory that sell for $5 apiece on average.
As you can see, your inventory valuation method will depend on your business model and products. However, the most common methods are specific identifications and FIFO.
What Else Can You Value for Your Business?
Your inventory isn’t the only part of your business that can be valued. Any asset or liability can also be valued to understand your company’s worth. A few examples of items that go through the valuation process include property (your brick-and-mortar locations if you buy the land), your company fleet, the equipment you use, and even intangible assets like your brand and logo.
As your company’s value increases, you can potentially sell your business for more money or use your company as collateral to secure additional loans.
Valuation might seem like a complicated accounting term, but it becomes easier to understand once you put it into practice for your business. Keep learning about finance and business management through our Bookkeeping 101 guide from Sunrise. We’re here to help you grow.