A Less Subjective Method of Inventory Valuation
Recently, we’ve fielded questions about how asset based lenders evaluate inventory. The following is an article we wrote a few years ago that’s still applicable today. The policy outlined is one that we follow.
Asset based lending is a type of financing secured by an asset, and inventory is a business asset. As inventory is difficult to verify and track, and most times problematic to liquidate, asset based lenders typically provide a lower advance rate on inventory than on accounts receivables (50% vs. 85%, respectively).
To determine the borrowing base of inventory, lenders typically conduct a formal appraisal which is a subjective appraisal of an inventory’s worth. It also only captures the make-up and mix of the inventory at that point in time. A more objective method is to use specific criteria that speak to the inventory’s value in relation 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?
Turnover: 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?
Product Lifecycle: How much of the inventory is obsolete?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?
Physical Controls: 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?
Landlord Agreement: 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 and the borrowing levels relative to the borrowing against the accounts receivable. The following chart represents a good rule of thumb for determining an appropriate advance rate:
|Advance Rate||Debt/Tangible Net Worth|
|50%||3:1 or better|
|40%||3:1 – 5:1|
|30%||5:1 – 8:1|
|20%||8:1 – 10:1|
Some lenders will not consider providing an inventory line for companies whose debt-to-tangible net-worth ratios are greater than 10:1.
It is also critical to manage the client inventory borrowings vs. their accounts receivable borrowings. Many asset based lenders limit inventory borrowings to no more than 50% of the client’s accounts receivable borrowings unless the client has some other unencumbered assets of value that can be used to further secure the loan.
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 expect 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 expectations, however, the business is holding 10% more in finished goods than it should be. Therefore, the lender would discount the eligible inventory by 10%, or $1MM (10% of $10MM).
Turnover: 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).
Product Lifecycle: 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).
Physical Controls: 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 sum: 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.
About Celtic Capital
Companies looking for working capital to cover operating expenses, fund growth, increase buying power and take advantage of vendor discounts and rebates turn to Celtic Capital. With an appetite for the more complex transactions, Celtic Capital has a history of success in crafting creative, flexible asset based financing solutions from $500,000 to $5 million with no financial covenants.
As an independent lender, working with companies nationwide, Celtic Capital is willing and able to alter price and deal structure and expand lines of credit to handle its clients’ increased revenues; and when cash flow is an issue, will look toward providing an inventory facility to help offset lost cash flow.