Inventory as Collateral
Although most brokers / consultants will focus heavily on factoring as their primary product due to the residual nature of the commissions paid, you will still find many occasions where you are prospecting manufacturers and distributors who will require financing for their inventory as well as accounts receivable. Understanding the nature of inventory finance as part of an asset-based lending revolving line of credit will be important when making presentations to your leads and prospects.
Inventory as Collateral
In most cases, an asset-based line of credit provided to a borrower will include an inventory finance component and in some cases, will be strictly based upon inventory. This can be the case, for example, when a company is utilizing a factor for accounts finance but has grown in size to the point where inventory finance is now also required.
To understand the differences between inventory lending and lending upon accounts, two principles must be considered.
- An asset’s collateral value is a function of its liquidation value, not its market value.
- The value of any asset as collateral is directly and inversely related to the value of the borrowing company itself.
Because of these two principles, it is easy to understand why accounts receivable represent an excellent form of collateral and why inventory can be problematic. The liquidation value of an account receivable, for example, is almost always at or near its face value and is generally completely non-dependent upon the health of the borrowing company.
Inventory is a completely different matter. The ability to liquidate inventory can be highly dependent on dozens of extenuating factors such as quality or age. Additionally, the liquidation value of inventory can also be dependent upon the financial health of the manufacturer.
The value of inventory where the manufacturer is insolvent and can no longer warrantee or service the goods will clearly be less than that of a similar manufacturer which is in strong financial health and can still perform those services. From the asset-based lender’s viewpoint it is clear to understand that the value of inventory, or actually any asset for that matter is a contingent value and the only time it really matters is at the time of liquidation in the event of a default upon the loan. Good collateral, whether accounts or inventory, is that collateral which will not be affected by the bankruptcy of the business, from the standpoint of the asset-based lender.
Eligible Inventory for Lending
Inventory can be defined as…
“Stock of tangible property held for sale, material held for production of goods held for sale, or goods used in the normal course of business.”
For inventory to be eligible for finance, the borrower must have it in it’s possession and it must own it free and clear.
Inventory can progress through three basic stages…
- Raw Materials held for production
- Work in Progress
- Finished Goods
The value of inventory and its eligibility as collateral for asset-based finance depends significantly on what stage it is in. In other words, the overall value of inventory will be to a great degree determined by whether it is a finished product or not.
Inventory Advance Rates
Advance rates upon inventory will almost always be considerably less than the typical 80% advance rates onaccounts receivable due to three principle reasons…
- First…inventory is much less liquid than accounts receivable
- Second…its valuation is much more difficult to define
- Third…it is more difficult to effectively control
In the event of default, inventory must be liquidated at the going liquidation value. Unlike accounts which will self-liquidate for cash, generally within 90 days, liquidating inventory most often involves a process such as an auction.
Inventory also cannot be “lockboxed”. Although the borrower’s inventory will be periodically audited with the lender by sending in staff to actually perform a count, inventory can become difficult to control and is much less verifiable in the event of a pending default by the borrower.
The question of advance rates on inventory, is therefore, difficult to sometimes quantify and based heavily on the quality of the inventory. In general, 50% advances on finished goods are normally inline with most asset-based lender’s formulas with unfinished goods and difficult inventory considerable less.
