The St Louis Fed publishes monthly inventory levels, with the most recent data being March 2023. The FRED graph shows the millions of dollars invested in inventory during the five year period from March of 2018 to March of 2023. Prior to the pandemic, inventory levels peaked at $2,048,565 million. During the supply chain issues in 2020 and 2021 inventory reached a low of $1,918,868 million in June of 2020. In the fourth quarter of 2021 inventory levels reached pre pandemic levels and are now at $2,490,045 million in March of 2023.
This 25% increase in inventory levels is stressing company cash flows, borrowing base compliance, and valuations in liquidations.
What should borrowers and lenders do?
Looking at overall inventory turnover is not sufficient. As cash tightens, companies typically have more slow-moving inventory and less of the inventory they are able to reliably sell through existing channels.
Here are tools that can help analyze the ability to convert inventory to cash, and over what time period that conversion could occur.
Ask for these reports:
Inventory by SKU.
Sales by SKU, trailing twelve months and last fiscal year.
Inventory aging by category.
Sale price compared to inventory value.
Use this information to calculate turnover by SKU, number of months inventory on hand by SKU, and margin expectations by SKU. Also review the inventory aging to establish when inventory on hand was received. Look for slow moving and aged inventory to be an increasing percentage of the total investment in inventory.
Consider the higher interest carrying costs occurring now, to better evaluate the cost benefit of converting inventory to cash today versus holding for sale sometime in the future.
Looking at this information will give a company a better sense of their excess inventory and will help the lender and the company come to an agreement on how to deal with debt structures, especially ABL structures, during a planned inventory reduction. Develop a weekly cash flow and working capital forecast that will not only allow preparation of accounts receivable, inventory and accounts payable roll forwards, but will allow development of roll forwards by key customers and key vendors. This is especially important when a company finds itself in the position of needing to bring in more of the faster moving inventory from existing vendors while still working down inventory levels and the accounts payable balances.
It is also critical to understand freight in, tariffs, and payables to vendors. This information is extremely critical in an inventory liquidation or reduction scenario. Questions to ask include:
Is any inventory located in Free Trade Zones (“FTZs”)?
Of the inventory located in FTZs, how much is subject to what level of tariffs?
Even if title to inventory transfers at the time the container is loaded, vendors often provide terms. In one situation, a vendor provided 100 day terms. Consider the loan documentation related to this type of situation and the ability of legal arguments to prevail.
Determine who pays the freight and what the payments status might be.
Lenders should also reevaluate their understanding of inventory valuation. The higher container transport costs may result in hidden costs that will flow through the income statement. Companies have experienced inventory adjustments if they capitalized freight costs. Sometimes even if the company does not specifically capitalize freight into inventory, the company holds freight expenses in balance sheet accounts and then matches freight costs to inventory as inventory is sold. This can result in a longer period of lower profitability as those higher costs or higher inventory values work through the sale process. Some companies have recorded the earnings impact of the freight costs, at least in part, during the prior fiscal year. It will be important to thoroughly understand the potential hidden costs and income statement impacts both as recorded in the prior year and to be recorded as existing inventory is sold.
Taking the time to do a deeper dive into inventory will help both the company and the lender better deal with the combination of higher investments in inventory, changing consumer tastes impacting inventory turnover, higher interest rates, and working capital management concerns. Preparing the type of inventory analysis described in this article should reduce unexpected expenses during a liquidation or reduction of inventory levels, and help both the borrower and the lender set proper expectations of the financial impact and the time required to right size inventory.
Contact FMG if you have questions or would like to discuss a specific situation of concern. We look forward to talking with you.