The traditional approach lenders take to evaluate how much they’ll lend on inventory is to hire an appraiser, with industry expertise, to conduct an evaluation for them. The appraiser generates a report detailing what would happen in a liquidation scenario. The report would include a complete description of the inventory, its value (both by component and in total), the time and expense needed to liquidate it, whether or not work in process (WIP) would have to be completed to sell it, and how raw material would best be handled.
There are several inherent weaknesses in this approach: an appraisal is a subjective measure of an inventory’s worth, the current appraised value may not be representative of its value in the future, and the appraiser may not be sufficiently knowledgeable about the category of inventory to accurately determine its possible value.
There is another approach to inventory valuation, which may or may not include a professional appraisal; the decision to obtain an appraisal will depend on how well versed the lender is with the category of inventory in question. Using this alternate method, lenders make their lending decisions based on the value the inventory has to the ongoing operation of the business.
Using the alternate method, lenders analyze the following aspects of the business: type of business, turnover, obsolescence, reporting and net worth.
– Type of Business. Businesses vary in the amount of finished goods they require in their inventory. A company that makes “build to order” products, for example, will have a different mix of raw materials, WIP and finished goods than another type of business.
– Turnover. How is the inventory performing? Does it turn quickly? What’s the historical rate of turnover?
– Obsolescence. How much of the inventory is obsolete?
– Reporting. How accurate and current is the reporting? Do test counts match up? Is there any large variance? Are the listed costs accurate? What physical control is there over the inventory? Is it located in one place or scattered over many locations?
– Net Worth of Business. The bigger 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 all come into play and are thoroughly reviewed.
The outcome of this type of analysis will determine the lender’s 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 will be given. This is a much less subjective measure of an inventory’s value than the traditional appraisal method, and with this method, the lender can see the exact impact each component of the business has on the inventory’s borrowing power. The following is an example of this valuation method.
– Type of Business. Let’s say a business has inventory valued at $10 million and the business makes inventory to stock. Lenders usually want to see the inventory distributed as 10 percent to 30 percent in raw materials, 20 percent to 50 percent in WIP, and 20 percent to 50 percent in finished goods. If the actual distribution is 10 percent raw material, 30 percent WIP and 60 percent finished goods, both raw material and WIP are within the lender’s formula. However, finished goods are 10 percent over this formula. Therefore, the lender would discount the lending limit by 10 percent, or $1 million (10 percent of 10 million).
– Turnover. Inventory that turns five or more times would not be discounted. However, the lender would discount all inventory that turns more than once, and would apply a 50 percent discount to inventory that turns three times a year. Let’s say this company has $400,000 that turns once, and $2 million that turns three times. The lender, therefore, will discount $1.4 million (all of the $400,000 plus half of the $2 million).
– Obsolescence. The lender says it will discount all obsolete inventory. If an analysis shows that 5 percent of this company’s inventory is obsolete, inventory will be discounted by $500,000 (5 percent of $10 million).
– Reporting. For purposes of this example, counts are off by 10 percent, which leads to a discount of $1 million (10 percent of $10 million).
Upon completion of this in-depth evaluation, the lender knows that of the $10 million in inventory, $3.9 million has been discounted ($1 million for business type, $1.4 million for turnover, $500,000 for obsolescence, and $1 million for reporting inconsistencies). This leaves $6.1 million of eligible inventory against which the lender will advance between 20 percent and 70 percent, based on the lender’s comfort level with the type of inventory and the net worth/profitability of the business. As the issues identified are cleaned-up (i.e. reporting inconsistencies, obsolescent inventory), no discounts will be taken and the borrowing base will rise.
This alternate method of inventory valuation is a win-win situation lenders are basing their loan policy on more objective criteria, and borrowers are provided with a strong incentive to improve control over, and management of, their inventory, which in turn will provide an ongoing evaluation and warning system of potential problems down the road.
Evon G. Rosen is Senior Vice President and Director of Marketing for Celtic Capital Corporation, a provider of asset based capital. Ms. Rosen can be reached at email@example.com
Entrepreneur’s Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.