In the early 1970s, the asset-based lending section of Bankers Trust was called ‘Accounts Receivable Financing’. This was because loans were extended exclusively against receivables, although inventory was taken as additional collateral in most cases. Several years later, with the evolution of inventory lending, token advances of 10 percent to 20 percent were made. Sixteen years on, advances up to as much as 85 percent were made in rare cases. Today, the most quoted rate is 50 percent. Over time, have we learned much more about inventory, or has the competitive environment in which we now operate forced our hands? The answer is probably a little of both. For those of us who still have some trepidation and apprehension when it comes to inventory lending, the most vital key is common sense. This is not rocket science.

Initial considerations

Any decision to lend against a borrower’s inventory should be preceded by three important questions:

• What is it?
• Where is it?
• Who do I sell it to?

Given that asset-based lenders are supposed to structure every deal from a liquidation perspective, these questions are best answered up front rather than later. The ‘What is it?’ question suggests that the lender should have a comprehensive knowledge of the inventory so as to determine the market dynamics of the product. The ‘Where is it?’ question lends itself to the difficulty or ease in the lender ‘taking possession’ should that become necessary. Lastly, the ‘Who do I sell it to?’ attempts to define the market for disposition should the lender take possession.

Seeing the inventory

Before deciding to lend against the inventory, the lender should see the inventory. Taking a tour of the facilities gives the lender first knowledge of the inventory. The lender should view the entire inventory against which it will lend. Unlike the analysis on receivables, which is largely quantitative, the analysis of inventory is largely qualitative. A visit to the site(s) should take the following issues into consideration:

Nature. The lender should assess the type of inventory to determine whether it is unique in some sense or broad-based. One needs to remember that generally, the bigger the marketplace the easier the effort to dispose of the inventory. If you have never heard of the product, more than likely it has a limited market and that will negatively impact the value the lender receives in liquidation.

Number of locations. Knowing the number of locations is necessary as it has to do with the control issue in an ongoing relationship. It is even more important in a liquidation scenario. Certainly, multiple locations will add some degree of difficulty and increased costs to any liquidation effort, both of which will be borne by the lender.

Seasonality of inventory. One should consider whether or not the inventory has any seasonal features to it. For example, if the prospect manufactures artificial Christmas trees and the lender visits the company on 27 December to see goods stacked to the ceiling, this is not a good sign. Other products can be seasonally based by virtue of their geographical location. Air conditioners, for example, are not seasonal in Florida but are most definitely so in New York.

Understanding the production cycle. If the lender understands the production cycle, it can figure out if the inventory is correctly valued when reviewing the records. For example, if the company’s manufacturing process simply involves bolting two pieces of widgets together to create a finished product, then the product is more material-intensive than it is labour-intensive. When a lender looks at the valuation, materials should be the major component of any manufactured goods. Many companies have a way of adding costs to inventory that add no value and will bring no return in liquidation. Another aspect of understanding the production cycle is to try to ascertain how long the conversion cycle takes, because although lenders do not traditionally lend against work in process, it might become valuable in liquidation if the production cycle is relatively short. The lender might choose to fund the necessary labour and overhead to convert work in process to finished goods and sell these finished goods to help pay off the facility.

Storage conditions. Upon seeing the inventory, lenders should determine if there are any storage conditions unique to the type of product. Remember, these assets belong to the lender and it may have to take possession of them.

Security. Because the inventory is now the lender’s collateral, security should be of paramount importance. All the necessary safeguards should be in place, especially on items of small size and high value. These items tend to grow legs and walk away when a company experiences trouble.

What should be ineligible?

A frequently asked question is ‘What inventory should be ineligible?’ Instead of trying to enumerate ineligibles, a lender should think about liquidation. So the general answer is, ‘Anything that has a questionable value in liquidation should be made ineligible.’ The list might include work in process, goods in third party possession, proprietary items, slow and obsolete items, packaging and cartons, etc. The list could include several other categories, but if the lender remembers the general description it should make the right assessment every time. One word of caution: there is no substitute for common sense. For example, some packaging is an integral part of inventory, without which that inventory might be worthless. What sells Coca-Cola or Pierre Cardin cologne? The packaging might be of equal or greater value that the product itself.

A lender cannot arbitrarily exclude assets that are work in process without some thought. Take the case of a fabric manufacturing plant. The stage of the fabric before it is dyed into specific colours is called ‘griege goods’, which the company classified as work in process. Once the process was understood, griege goods were included into the borrowing base and at a higher advance rate than finished goods, since the work in process was more flexible in application than finished goods. Consequently, the transaction was structured with tiered advance rates for three separate segments of inventory.

What should the advance rate be?

Time and time again, lenders ask the question ‘What should the advance rate on inventory be? Unfortunately, it is very difficult to provide an answer. Why? Because if inventory lending was approached from a liquidation perspective, the inventory would have to be thoroughly examined in consultation with professionals who have inventory liquidation experience, before an opinion on the advance rate could be given. A liquidation perspective should influence the approach to the advance rate. Therefore, before entering the facility, lenders need to know where the exits are. Figure 1 represents a systematic approach to establishing an advance rate.

At survey stage, the lender has to attempt to quantify the exit costs. This is just an educated guess, so the lender should take a conservative approach. The average research value is the result that the lender derives from conversing with liquidators who do this for a living. It is not a good idea for the lender to ‘wing it’. The exit costs are inclusive of all anticipated expenses including Reservation of Title (ROT) and Purchase Money Security Interest (PMSI) set asides.

Summation

People sometimes refer to inventory specialists as experts. That means they supposedly have acquired some knowledge about this topic over the years that puts them head and shoulders above anyone else. That might be partially true, but common sense trumps everything else. Success in the inventory lending area does not  have to be difficult; it’s the result of using good common sense.