Take a Second Look at Inventory During the Next Line Renewal
- Juanita Schwartzkopf
- Oct 24
- 5 min read
As lenders are considering ABL line renewals and reviewing appraisals and field exams, it may be time to take a second look at inventory. Over the past year, FMG has seen some recurring themes related to inventory.
Inventory Aging Data
It is easy for borrowers to provide inventory aging reports in a similar format to accounts receivable and accounts payable aging reports.
Look at those reports by inventory category – raw materials, WIP, and finished goods. WIP inventory should not age if it is truly able to be converted to finished goods.
Effective and efficient operations should turn WIP inventory quickly. If you see WIP increase without a corresponding increase in sales volume, there may be an operations issue that is slowing down the conversion cycle.
If inventory is customer specific, consider the aging by customer and identify customers that are no longer active. Customers with a high level of inventory compared to the sales run rate could indicate a borrower is manufacturing to stock rather than to order, or the customer relationship is at risk.
Verify with your borrower that a customer contract or blanket purchase order, clearly identifies the “take or pay” agreements. If there is aged customer specific inventory, it may be related to quality concerns or lack of meeting acceptance criteria.
Relate inventory to accounts payable, especially in the raw materials category, to identify potential supply problems.
Capitalized Costs
Look for capitalized costs in inventory. Borrowers are able to move dollars to the balance sheet and improve the income statement if more value is added to the capitalized costs in inventory.
Consider the last time standard costs were updated. It is important the borrower conducts a thorough review and evaluation of standard costs at least annually.
Consider the type of inventory valuation method – FIFO, LIFO, NRV, for example. The selection of each of those methods impacts the income statement and the balance sheet. That impact is felt in the current year, and in the year those assets are sold. The valuation method also impacts the recovery estimates in a liquidation. While many inventory valuation methods are GAAP approved, the appraiser, the field examiner and the lender need to consider financial statement impacts of the various methods which can be used.
Consider whether freight is capitalized. While this was a serious problem during the Covid supply chain issues era, impacts have lingered.
Turnover by SKU
Evaluate the appraisal and the field exam for use of turnover by SKU data. If turnover by SKU is not included in those reports, ask why it was not included. Require the turnover by SKU analysis for the next report or have a lender credit analyst prepare the analysis.
Finished Goods May Contain Component Parts
Companies that manufacture component parts in the process of creating the final finished goods may classify the component parts as finished goods or as work in process. Lenders need to understand which approach is used.
If component parts are in finished goods, review of the aging of those component parts is critical. The assignment of component parts to specific customers should also be reviewed.
Irrespective of where component parts are in inventory categories, evaluate whether the relationships between component parts relative to completion to a final salable product are in sync?
Manufacture to Order, Manufacture to Stock
Does the company manufacture to order or to stock?
If the company manufactures to order, does the inventory aging show old inventory? That may be a clue there is a problem with the product in inventory. Inventory manufactured to order should not age out.
If the company manufactures to stock, evaluate the turnover by SKU carefully. Companies may convert inventory from raw materials to finished goods to improve overall ABL availability, but the sales conversion may be slower than expected.
How Does the Company Report Rework and Returns?
Rework and returns could relate to manufacturing process issues. Look for increases in either of these categories. Look for other new names or similar names in the inventory report.
Consider how returns are reported? Are they added to finished goods, work in process, or are they in a separate category for returns?
Shipped on Site
Some companies have customers that request product be delivered in minimum quantities. While awaiting shipment, typically that product is in finished goods.
An ABL borrower may be able to increase their availability by classifying some of the inventory as “shipped on site” and creating an invoice to bolster accounts receivable.
Also Ask These Questions
When was the last physical count of inventory completed? What adjustments were made?
If inventory is subject to date expirations, how is that tracked in the borrower’s inventory system and how does the warehouse slot inventory to effectively rotate stock?
Have any new categories been added to inventory?
Has the relationship between inventory categories (raw materials, work in process, finished goods) changed?
Has the relationship between accounts receivable and inventory changed?
Have AR charge backs changed by customer or by product?
What Should Lenders Consider?
If a lender made loans based on true liquidation values, it would be difficult to compete for new loans. But a lender can evaluate the various data points related to inventory to evaluate the risk in liquidating inventory. Most importantly, analyzing these inventory related data points can provide early warning of a financial or operating performance problem.
As lenders are evaluating field exams, appraisals and BBC reporting, lenders may want to:
Ask for inventory agings with the BBC submission.
Consider the tug between the EBITDA performance and fixed charge coverage ratios versus the ABL impacts when reviewing capitalized costs in inventory.
Consider concentration limits on inventory by customer in a similar way as one evaluates accounts receivable concentrations by customer.
Adapt field exam work authorizations to include a deeper analysis of inventory, using the discussion areas noted in this article.
Quiz appraisers on their review of work in process inventory and their assumptions related to cost to complete for raw materials and finished goods. Ask appraisers what assumptions they have made when determining the ability to convert existing inventory to salable goods. For example, how has the appraiser evaluated the relationships between component parts, raw materials and WIP in general. Consider sending different appraisers or field examiners out for the next scheduled reports. A new perspective in laying eyes on inventory and walking the facility may turn up key data points for follow up.
If you would like to discuss this topic please give us a call. We are happy to talk through questions and issues with borrowers you are working with.
J. Tim Pruban
President, email: t.pruban@focusmg.com | cell (813) 918.7488
Juanita Schwartzkopf
Sr Managing Director, email j.schwartzkopf@focusmg.com | cell (520) 203.2926
Joe Karel
Managing Director, email j.karel@focusmg.com | cell (312) 307.1541