Inventory stacked in the warehouse

How to Evaluate Inventory

Inventory is generally one of the most over-rated assets that any business can hold. Business owners usually love to have it in the warehouse or on the shelves but, for lenders, it’s the worst possible asset to have too much of.

The two key questions

When we look at a business’ inventory there are two key questions that we have to ask;

  1. “How accurate are the values shown in the balance sheet?”
  2. “How quickly will the inventory be converted into cash?”

The figure for inventory that you see in the balance sheet reflects its value at the lower of its cost or its net realisable value (i.e. what the inventory could be sold for in the current market – in theory, at least).

The type of business will determine the inventory value

How we analyse the value to us of the inventory will depend very much on the type of business we’re looking at;

Service businesses will not have any at all.

Retail and distribution businesses will have inventory that is made up of products purchased from a supplier and ready for sale to its customers.

Generally, this type of inventory is preferable from lender’s perspective as its already in a saleable format. So in an emergency or in a liquidation, it could be easily converted to cash although it might be necessary to sell it at a deep discount.

Manufacturing businesses will have inventory that is made up of three parts;

  • Raw materials. Provided they are used by a wide range of manufacturers and could be sold to them to raise cash, these are useful for lenders after finished goods. If the raw materials are quite unusual and used in a very specific manufacturing process, then there may not be a ready market for them. So we would be forced to largely discount their value.
  • Work in progress is raw materials that have started the manufacturing process but have not yet been turned into finished goods ready for sale. These are virtually worthless to a lender as, if the business failed, there would be little likelihood that anyone would buy this incomplete inventory.
  • Finished goods. These are preferable for lenders as they could be more easily converted to cash in a hurry.

So, what this means is that when you’re analysing a manufacturing business, you should ideally try to determine the components of the inventory figure and not simply take the total as being of value.

The term “net realisable value” implies that the inventory value is a true representation of what the inventory is actually worth in the normal course of business. That suggests that any inventory that is worth less than it initially cost has been reduced in value.

Don’t rely on the inventory value in the balance sheet being realistic

The problem is that doing so requires the managers of the business to accept the reality that inventory has fallen in value. That could happen because the inventory is damaged, is technically obsolete or is just not wanted by the customers for whatever reason.

Managers are not keen to accept that reality however. The chances are that an inventory value on the balance sheet will still include inventory valued at cost and not at its reduced, realistic value. It’s not easy to see that from the reading the financial statements or, indeed, even viewing the inventory first-hand.

The only way to satisfy yourself that the inventory is correctly valued is by asking questions of the managers and, perhaps, the accountant or auditors. Of course, there’s really only a need to do this when the value of inventory in the balance sheet is significant and is being relied on to eventually provide the business with the cash flow that will service debt.

Should banks lend to finance inventory?

Generally, the answer to that question is, no. The managers of the business should finance inventory through the use of credit terms offered by the suppliers. If the inventory is held for a longer period than the credit terms, it’s possible that the credit terms negotiated with the suppliers are too short.

The problem for you as a lender is that if you finance the inventory, the danger exists that it may never be sold (for reasons explained earlier) and so there may never be cash flow to repay the debt.

One of the most common situations that banks experience is when a business customer obtains a large contract to supply product to a large organisation or worse, a government department. Often, the contract requires that the business acquires significantly more inventory than usual to satisfy the contract obligations. Naturally, the business requires that inventory to be financed because the suppliers are wary about extending a much higher level of credit to the business and the business doesn’t have the cash to finance the inventory purchase itself.

The big danger here is that the business acquires the product as planned but then the contract is cancelled by the large organisation or the government department for whatever reason. That leaves the bank with the problem of waiting for the inventory to be sold in small quantities over time to get repaid. if the inventory is very specialised and there are few alternative customers for it, it may never be sold. Or, if it is, it may be for a much lower amount that it cost initially.

Can inventory be used as collateral?

Some banks do this as part of a general legal claim on the assets of a business. As mentioned earlier, the real value of inventory depends very much on the type of business. So, the value of inventory to the bank as collateral is affected by that also. Plus, the inventory level in a business is changing almost daily so it’s really very difficult to place a value on the collateral at any point.

There may be some small value to the bank in having inventory as collateral but that would only be in a liquidation situation by which time most of the assets that could generate some cash flow will have been disposed of the business’ management – including the saleable inventory.

Read the article “How to Evaluate Current Assets” for more on this topic.

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