Trust But Verify
By: Juanita Schwartzkopf, Managing Director
The field audit arrives and lists 5,700 tons of potash in inventory. At current prices this potash is valued at $2.85 million. With a 50% advance rate, the borrower owes $1.42 million based on this inventory level and current availability.
Based on a density of 75 pounds per cubic foot. Converting tons to pounds and then dividing by 75 equals approximately 152,000 cubic feet. Note that 152,000 cubic feet of potash would produce a cube 53 feet tall, 53 feet wide and 53 feet deep. Putting this into perspective, that is a five story tall mound of potash.
Assuming the size of the operation supports a five story tall mound of potash, the loan advance may be well supported by collateral.
What does verify mean?
If a borrower reports 10,000 tons or 750,000 gallons of an inventory item, it is necessary to independently verify the volume that a ton, pound or gallon of this inventory would occupy. Most chemicals or substances have published Material Safety Data Sheets (MSDS) that are quickly found online. The MSDS will give specific weights, densities and weight per cubic foot of substances. With this information and some quick math, it is possible to convert unfamiliar units of measure into blocks of space that can be evaluated for reasonableness.
By using this approach on the 5,700 tons of potash reported in inventory in the example above, the reader of the field audit or borrowing base creates the ability to apply the context of space to a very large number on an inventory report.
Two more examples
Converting inventory into truckloads or railcar loads is also a way to test for reasonableness. Asking a few questions from employees on site could provide reasonable estimates of the amount of product that typically arrives in a “truckload.” A truckload of product could be 50,000 pounds. Using the same potash example of 5,700 tons, this inventory level equates to 228 truckloads. Is this reasonable?
Consider the example of a manufacturing company with inventory in transit on its borrowing base certificate. The company packages its product in pallets and ships via over the road carriers. A simple calculation of number of pallets per truckload, and product per pallet, provides an ability to compare the number of trucks reported to be filled with inventory in transit against the number of trucks the company has on the road at any point in time. – whether owned, leased or contracted.
What should we learn?
Lenders and financial advisors often receive borrowing base certificates and field audits filled with numbers that are difficult to visualize and, therefore, difficult to understand. The difficulties are both related to developing a perspective of the collateral, and developing a perspective of the relationship of the collateral to the performance of the company.
In several of the examples, it was clear the inventory numbers were so large, and the product so unique, that a lender may not have experience that provides the base for comparing the reported levels of inventory to the operations of the business.
In other examples, the lender’s files have multiple sources of data (acres planted, building dimensions, number of trucks owned, unit sales price per product), which need to be compared. Conducting the high level comparison described would highlight areas for further discussion.
It is imperative that simple tests of reasonableness be applied to the information presented. The time invested in this type of review and analysis is key to uncovering problems with the asset quantities and values before a serious problem develops.
Focus Management Group always applies these tests of reasonableness to its financial review of borrowers. In the case of the manufacturing company, Focus was able to uncover the borrowing base problem before the lender advanced on inventory in transit.
Focus Management Group has been involved in reviews and verifications of field audits for many years, and has worked with lenders as potential fraud situations are uncovered. Focus Management Group is a leading business restructuring firm headquartered in Tampa, with offices in Atlanta, Chicago, Cleveland, Dallas, and Los Angeles. For more information on our experience with successful turnarounds or restructuring in the Manufacturing Industry, contact us.
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