A Less Subjective Method of Inventory Valuation
As inventory is in the borrower’s control, thereby making it difficult to verify and track, advancing on it has never been a lender’s asset of choice. In addition, inventory can be problematic to liquidate. That being said, a competitive marketplace forces lenders to look at inventory in the borrowing base. The trick then becomes how to best evaluate it to make the lender comfortable lending against it. While conducting a formal appraisal is the traditional approach, that is a subjective measure of an inventory’s worth. A more objective method is to use specific criteria to look at the inventory’s value in relations to the ongoing operation of the business. This allows both the lender and the borrower to understand the impact each of the criteria has to the inventory’s borrowing power. Using this approach, lenders look at and analyze the following:
Match to Business Model
Some businesses should carry hardly any finished goods; some more. What mix of raw materials, WIP and finished goods makes sense for this company?
How is the inventory performing relative to the industry? What’s the historical rate of turnover? Can you break out the turn by type of inventory? By component?
How much of the inventory is obsolete?How quickly does it become obsolete?
Accuracy of Records
How accurate and current is the reporting versus the physical counts? Do test counts match the reporting? Are the listed costs accurate based on recent purchases?
What physical controls are there over the inventory? Does everyone have access to it?
Is the inventory located in one place or scattered among multiple locations?
If the inventory needed to be liquidated, is an Agreement with the landlord in place to enable continued access to the property for a set time period to facilitate an orderly liquidation?
Net Worth of Business
The greater the net worth, the more likely the business will be able to overcome any bumps in the road and, therefore, the less likely the lender will have to liquidate inventory. Net worth, cash flow and profitability are monitored and used to determine the advance rate.
The outcome of this analysis determines the lender’s inventory loan policy.If issues of concern to the lender are identified, the loan amount will be discounted.Conversely, if no issues come up, no discounts are given.
An example follows:
Match to Business Model
Let’s say a business has inventory valued at $10MM and that the business makes inventory to stock. The lender may want to see the inventory distributed with 10%-30% in raw materials, 20%-50% in WIP and 20% to 50% in finished goods. If the actual distribution is 10%, 30% and 60% respectively, both raw material and WIP are within the lender’s formula, however, finished goods is out of formula by 10%. Therefore, the lender would discount the lending limit by 10%, or $1MM (10% of $10MM).
Inventory that turns six or more times annually would not be discounted.However, the lender would discount all of the inventory that turns less than once a year and would apply a 50% discount to inventory that turns two times a year. Let’s say this company has $400k that turns once and $2MM that turns two times. The lender will discount $1.4MM (all of the $400k + half of the $2MM).
The lender says it will discount the entire obsolete inventory. If an analysis shows that 5% of this company’s inventory is obsolete, inventory will be discounted by $500k (5% of $10MM).
Accuracy of Records
For purposed of this example, counts are off by 10% which leads to a discount of $1MM (10% of $10MM).
Of all the criteria, this is the only purely subjective one; there is no calculation. Applying a discount for physical controls is solely at the discretion of the lender; and, if for one reason or another the lender wants to beef up the ineligibles, this is where it’s done.For purposes of this example, no discount is given for physical controls.
Upon completion of this analysis, the lender knows that of the $10MM in inventory, $3.9MM has been discounted ($1MM for match-to-business model; $1.4MM for turnover; $500k for product lifecycle and $1MM for accuracy of records. This leaves $6.1MM of eligible inventory against which the lender will advance between 20% and 50% depending on the lender’s comfort level with the type of inventory and the net worth/profitability of the business. As the issues leading to the discounts are cleaned up (i.e. obsolete inventory, reporting inconsistencies), the amount of the inventory borrowing base may increase. When lenders see relatively low levels of ineligibles, it tells them that this asset is being managed well. And when companies manage their inventories well, it usually means they’re also running their businesses well.
In summary: this in-depth objective inventory valuation method provides lenders with a loan policy they can live with and provides borrowers with a strong incentive to improve control over, and management of, their inventory; a win-win for all.