10 Critical Inventory Value Monitoring Points

ARTICLE

Date December 2013

Inventory is excellent collateral for asset-based lenders, though it's critical to understand all the issues surrounding the asset, including the key collateral monitoring factors. By identifying and monitoring certain factors that have a direct impact on the inventory, lenders can gain an understanding as to how these factors directly impact the collateral when establishing and monitoring loans secured by inventory.

Although the critical points likely will vary by inventory type and industry, here are the 10 most common inventory value monitoring points.

1. Inventory mix. The overall mix in inventory between classifications (i.e., raw materials, work-in-process and finished goods) will impact the overall value, as each class of inventory typically generates different liquidation values in relation to cost. It's important that a lender monitor the inventory mix to ensure that low-recovering inventories (slow-moving, excess, obsolete, aged and so on) do not become a disproportionate part of the overall inventory, as this would reduce the overall liquidation value of the collateral. It's also critical to understand that in a distressed scenario, the absence of working capital often results in a company selling as much of the saleable inventory as possible to generate cash for operations. This would likely negatively affect the inventory mix and diminish the overall value. Selling prime inventory is often an attractive option to troubled companies because it's a short-term solution that's also simple, effective and, on its surface, not a cause for alarm.

2. Inventory turnover. A company's inventory typically consists of items that are consumed in the production of items and/or items that are sold in the normal course of business. General historic usage and sales demand on the inventory would provide some indication of the relative demand for the inventory in the marketplace, which should be related to the overall liquidation value. An increase in the overall activity would point to a relative improvement in inventory value, whereas a decrease could indicate devaluation.

3. Inventory aging. A company often maintains detailed records on its inventory, as to when it was received or produced. Any deterioration in the age of the inventory could be a sign of deteriorating market conditions, a high rate of cancelled orders and/or the company's inability to keep its inventory current. An increased buildup of aged inventory could indicate the need to adjust the liquidation valuation rates of the inventory, as aged inventory likely will have lower recovery rates than inventory that is less aged. This factor can be even more critical when dealing with inventories with defined shelf lives, such as perishable items. Items that are short-dated or even expired can have recovery rates that are substantially lower than non-aged items.

4. Inventory cost review. The cost basis of the inventory should be monitored carefully because a significant fluctuation could materially affect the liquidation value as a percentage of the inventory cost. The inventory cost is dependent on the company's costing methodology. Companies that utilize a standard cost methodology typically establish standards on an annual basis. Standard rates often vary in relation to the market price and, depending on whether the rate is higher or lower than market, can have a negative or positive impact on the inventory value as it relates to its stated cost. Companies that utilize an average or actual costing methodology also can experience variances in costs as they relate to market prices, with variances primarily being impacted by market price shifts in the products they purchase versus the trailing average cost of the items being held in the inventory. Companies that utilize a mark-to market, lower-of-cost or market approach when costing the inventory typically see little to no variance in cost related to market.

5. Gross margins. Gross margins can be monitored from the company's financial income statements or other types of gross margin reports. A decline in gross margin typically provides an early warning of a decline in demand and/or the pricing strength of an inventory. Often, the values of the finished goods are driven by the finished selling price of the company's various products. The company's margin is dictated by the cost to procure raw materials and produce finished goods versus their selling prices. As this spread narrows and gross margins compact, it would be likely that the liquidation value as a percentage of the cost would decline.

6. Loss of key customers. The loss of key customers could measurably impact the liquidation value of inventory. Typically, the valuation of finished goods is dependent on the assumption that finished goods (subject to open orders and solid historical sales demand) would be purchased at or near their traditional selling prices to fill customers' production or stocking requirements. With the absence of key customers purchasing inventory in a liquidation scenario, the recovery proceeds could be significantly lower.

7. Downturn in industry/economy. The strength of the industry and economy in which the inventory is sold likely would impact the liquidation value of inventory. A weakening of the demand or lower prices could impact the company's margin or operating structure and directly, negatively impact the liquidation value of inventory.

8. Proprietary inventory. A company's inventory might include items that are proprietary to the company or its operations and products. Proprietary inventory might not be usable by other market participants, such as competitors, unless they adopt some of the company's product lines or offerings. As such, it's likely that proprietary inventory would not attract commercial interest under a liquidation scenario, unless an assumption was made regarding the customer's willingness to buy. This could have a negative effect on an inventory's recovery values.

9. Regulatory and compliance.
A company should be in compliance with all rules and regulations that affect the company and its inventory distribution. Further, all regulatory encumbrances, if any, on the inventory in a liquidation scenario should be understood and accounted for. A company's failure to remain in compliance could result in regulatory sanctions or restrictions that could impact the marketability of the inventory.

10. Product return rates. A high rate of finished-good product returns could signal product-quality issues or a declining market for the products being returned. This return rate should be monitored carefully, as an increase could negatively impact the overall orderly liquidation value of the company's inventory.

These points aren't all-encompassing, but asset-based lenders should consider these topics when using inventory as collateral and give consideration when needed. Often, simple monitoring and accurate appraisals can dramatically decrease the risk associated with these issues. Similarly, proper communication with valuation firms can help keep considerations such as these on the forefront.