April 4, 2017
By Andrew H. Moser | Originally printed in April 2017 issue of the Journal of Corporate Renewal
There are many important considerations to keep in mind when lending on inventory assets. Chief among them is understanding the differences between so-called lagging versus leading indicators when identifying and monitoring critical key performance indicators (KPIs) in any given transaction. In today’s ever-changing and fast-paced environment, these must be monitored proactively and continuously, with a sound infrastructure in place to support timely decision making.
When structuring and reviewing diligence on a company’s inventory, one way to think about it is that lagging indicators have more than likely led the parties to where they are today, while leading indicators, if monitored closely by the lender, will provide a first indication of trouble spots that may lie ahead. In the case of positive performance trends, leading indicators may also reveal an opportunistic case for supporting enhanced collateral value. These leading indicators are those to which the lender must pay particular attention, as they often reveal early warning signs or key indicators that point to looming problems well ahead of traditional financial measures or covenants routinely considered at credit committees.
Leading indicators are unique in each situation and must be identified on a case-by-case basis. They should be studied with a critical eye and with input from qualified decision makers, ideally those with experience gained through multiple credit cycles and with direct experience regarding the specific asset class and/or industry subsector. Often, these indicators can point to serious developing financial trends that can lead to a liquidity crisis that would leave little time to intervene.
While these inventory KPIs are most often associated with, and most familiar in, retail or consumer transactions, the same concepts can be applied to almost any situation involving inventory assets. Generally speaking, when it comes to inventory, time is often not one’s friend, and if the necessary expertise does not exist in-house, a lender should be sure to seek qualified input from others more familiar with the specifics.
Often, the most critical mistake made when lending on inventory is assuming that having more inventory on hand is a “good thing” that will improve the lender’s position on the assets or collateral. This could not be further from the truth and can often lead to great difficulty in recovery.
While a natural and seemingly logical reaction is to assume that the more, the better, the reality is that too much inventory—an “overinventoried” position—could signal the beginning of many challenges to come related to the disposition strategy, including potential margin deterioration. Conversely, being “underinventoried” can also negatively impact a company’s ability to achieve its sales plans in a situation in which a balanced inventory is key to optimal performance in the normal course of business and to optimal collateral value.
To understand these issues, there are some basic concepts that are critically important in the disposition of inventory, the most notable of which include sales capacity, period volume, and related selling expenses. In the most basic terms, the normal period sales volume is the baseline from which one will determine the overall sales capacity or multiple of normal sales (period volume) that can be achieved given existing inventory levels during a defined period and under a specific disposition strategy. During any disposition, necessary selling expenses will be incurred to achieve stated sales objectives. Simply stated, if too much inventory exists, more time will be needed to sell the goods, a steeper discount cadence may be required, and, most likely, additional expenses will be incurred to achieve the desired results.
There is a direct correlation between the time needed to liquidate inventory and the associated sales expenses. In addition, and equally important, the concern remains that in an overinventoried position, the bottom one-third of the inventory on hand is likely to be “ballooning” (i.e., increasing), hampering the ability to replenish the top one-third of the inventory. As such, the more profitable (i.e., faster turning) asset is smaller as a percentage of the whole, leading to the inventory becoming stale and negatively impacting the ultimate realizable net recovery.
This speaks to what often occurs well ahead of any financial covenant breach. With proactive monitoring and safeguards in place, early warning signs can be identified and managed successfully to avoid future problems. The key is to identify these fundamental leading indicators and to structure loans with proper “safeguards and rails” (as the author refers to them) that allow lenders to follow and proactively measure successes and failures in achieving forecast results. When it comes to lending on inventory, no one standard measure or set of covenants applies to all.
These safeguards and rails are most easily associated with (1) maximum inventory levels, (2) levels of supply relative to sales (i.e., inventory turn), and (3) frequent, detailed analyses of inventory performance results associated with revenue and net selling gross margins. Trends derived from margin dollars in relation to operating expenses can also be a critical measure of performance, because after all, net margin dollars, not revenue, pay the bills.
The Path Forward
Successful lending on inventory assets requires deep and direct industry and credit experience spanning multiple credit cycles, ideally buttressed with a disciplined, proactive monitoring and realization of varied pools of collateral across many subassets or classes of inventory. This monitoring must follow and demonstrate knowledge of a path forward, identifying those factors needed to maintain value or provide input for determining the necessary critical path. No longer can lenders monitor effectively in their spare time or rely merely on historical results, projected recoveries based primarily on a financial forecast by the borrower, or an appraisal based on the borrower’s input.
The lender must work in concert with its appraiser to proactively monitor and look forward in evaluating these assets with a certain understanding that when it comes to inventory, time is often not a friend nor is having more of a perceived “good thing.” That said, a lender who understands the fundamentals and whose infrastructure is set to monitor these assets can often be a patient and reliable partner during the most difficult or challenging of times.