Assistant Vice President and Collateral Field Examiner
By Neha Malhotra, Assistant Vice President and Collateral Field Examiner
Not all types of inventory are treated the same when being considered as collateral within a lending agreement. Neha Malhotra follows up a previous article on accounts receivable ineligibles to discuss types of ineligible inventory as well as how such inventory is appraised from a lending perspective.
There is often a need for additional collateral when borrowers need additional availability on a line of credit. In such instances, inventory can become the natural lendable collateral after accounts receivable. As a note, bank lenders in particular look at inventory in conjunction with accounts receivable, often considering how “inventory reliant” a borrowing base structure can be when evaluating a credit risk profile.
Unfortunately, while getting availability using inventory as collateral can be very appealing to a borrower, for a lender, such a setup presents a set of risks that need to be carefully managed. For example, a lender often will lend to borrowers across various industries, resulting in varied responses for monitoring questions such as: Where is the inventory physically located? Is it fairly valued? Is the inventory accessible? Is it relatively new (non-obsolete) and salable? However, identifying and separating lendable inventory from non-lendable inventory can be a difficult practical challenge for lenders. To address this challenge and others, this article will focus on common ineligibles for inventory as collateral in the asset-based lending space for commercial and industrial finance. Specific details about lendable (or eligible) and non-lendable (or ineligible) inventory are a part of complex legal agreements signed between lenders and borrowers. While such legal agreements are very specific to each deal, conceptually, these agreements tend to follow a common concept: Any potential inventory that is quickly salable or able to be liquidated is lendable. But how do lenders determine what inventory meets these criteria?
INVENTORY APPRAISAL STRATEGIES
One of the strategies lenders use to appraise inventory is to identify net orderly liquidation value (NOLV), which is the value inventory appraisers put on a borrower’s inventory if it were to be liquidated on the day of the appraisal. The lender then discounts the NOLV using an advance rate to determine the final lendable inventory value. The advance rate for inventory is usually lower than advance rates for accounts receivable, which tend to be more liquid in nature.
Though an appraisal makes it easier for a lender to quantify the lendable inventory amount, regular appraisals can also add additional costs to a borrower, meaning it might not be a viable solution in the long term. An alternate option commonly used by lenders is to make inventory lending a part of borrowing base reporting.
To support inventory lending as a part of the borrowing base, borrowers are required to maintain robust reporting requirements, including submitting an inventory ineligible summary on the borrowing base. From a macro level, an inventory ineligible summary includes details on net lendable (or eligible) inventory, which is derived from total inventory after excluding non-lendable (or ineligible) inventory. The net lendable (or eligible) inventory is then discounted using an inventory advance rate to arrive at the final lendable inventory value, with different inventory categories (raw material, work-in process, finished goods, etc.) potentially leading to different advance rates. In this scenario, a borrower also is usually required to provide an inventory perpetual report and details about non-lendable inventory to support the lendable inventory value.
A perpetual report for inventory is a real-time report that tracks inventory on an ongoing basis at an item or SKU level. The report provides detailed and high-level insight into inventory categories, SKUs, locations, quantities, unit costs of each item and extended value of inventory at various levels. The dependability of the report is usually validated during a field exam via various inventory testing procedures. Availability of this report is a prerequisite to inventory lending, as in the absence of this report, there is no basis to use inventory as a collateral.
TYPES OF NON-LENDABLE INVENTORY
As previously discussed, non-lendable inventory (or inventory ineligibles) consists of inventory that might not be easily liquidated or sold quickly. From a lender’s standpoint, inventory that can be monitored, is accessible, in demand or not obsolete, can be sold to a customer/vendor and is owned free and clear is lendable inventory. Common categories for non-lendable inventory (or ineligibles) include packaging/supplies, damaged inventory, inventory outside the U.S., inventory without landlord waivers, consigned inventory, slow moving or obsolete inventory, and several others.
- Packaging & Supplies When a lender lends on inventory, the intent is to lend on a primary product that is ready to be sold or shipped. Packaging and supplies aid in getting the product ready to be shipped but are not primary product and hold minimum to no collateral value in the case of a liquidation scenario. Since packaging and supplies have minimum to no collateral value, they are not deemed to be an eligible collateral.
- Damaged Inventory If inventory is damaged, it is not salable, and since it’s not salable, it is not lendable.
- Inventory Outside the U.S. If the inventory in question is physically located in a warehouse outside the U.S., local commercial and industrial finance laws hold precedence over U.S.
jurisdiction laws. In case of a liquidation scenario, accessing this inventory might present unique and difficult challenges, depending on said local laws. Additionally, local and country specific laws also take precedence, and filing a priority lien on inventory might not be feasible. For the aforementioned reasons, inventory that is physically located outside the U.S. is often deemed ineligible. - Absence of Landlord Waivers Landlord waivers are needed in instances when inventory is stored at a location not owned by the borrower. If inventory is stored at such a third-party location, the landlord has access to the inventory and, in case of a liquidation scenario, if needed, can restrict access. A landlord waiver is a third-party agreement between the lender, borrower and the landlord affirming that if the lender needs to access the inventory, the landlord will grant access. In absence of landlord waivers, accessing inventory could pose a challenge for a lender in a liquidation scenario. Hence, if inventory is at a third-party location without landlord waivers, inventory is deemed ineligible.
- Consigned Inventory Consigned inventory is inventory stored at the borrower’s warehouse that is owned by the borrower’s vendors. In case of consigned inventory, vendors often send inventory to the borrower with an understanding that the invoice for the inventory will be paid once the inventory is sold. In these situations, due to their understanding with the vendors, borrowers do not technically own the inventory free and clear, making it ineligible collateral.
- Obsolete or Slow-Moving Inventory Operationally, inventory is ordered based on projections and expected to be ready just in time to be shipped to a customer. In an effort to be ready for customers, borrowers often order inventory in advance to avoid any potential delays at the last minute. Hence, most inventory that is purchased by a borrower sells through in a reasonable time frame. However, when inventory is not sold in a reasonable time frame, it initially is deemed to be slow moving and then, if it remains unsold for another reasonable time frame (more on this later), the inventory is deemed to be obsolete. For example, when a new phone model is launched, inventory for the prior model becomes slow moving, as the number of buyers reduces. Similarly, for the model prior to the older previous model, inventory would become obsolete, as a very small portion of buyers would be interested in buying the oldest model, ultimately reducing the salability of the product. Since neither slow-moving nor obsolete inventory is quickly salable, it is deemed non-lendable and ineligible.
Determining parameters of reasonable time frames is a major aspect in defining slow-moving and obsolete inventory. Reasonable time frames vary based on products sold by the borrower. For example, for a produce-related perishable product, inventory ideally would turn around in seven days or less. In that case, once inventory is beyond seven days, the likelihood of selling would start reducing. In such instances, inventory would potentially be deemed slow moving on the eighth and ninth day and obsolete on the 10th day. However, the same definition of reasonable time frame would not be applicable to fashion/apparel industries.
These common categories are not comprehensive in nature. Apart from these common categories, there are other industry-specific (e.g. work in process for manufacturing), debtor’s operational- specific (e.g. in-transit inventory for importers or distributors) and deal-specific (e.g. customer specific customized inventory) ineligibles. As such, the ineligible categories listed in this article are not comprehensive or exhaustive in nature. They tend to vary based on various factors and the terms of the final agreements made between a lender and a borrower. •
Neha Malhotra is an experienced field examiner in the asset-based lending and factoring industry. With a master’s degrees in finance from Texas Tech University and the University of Mumbai, Malhotra has a decade of experience and has worked with multiple financial institutions in the commercial lending space.
