Banking - Inventory Collateral

This segment will explain the essentials of how a bank evaluates the inventory that is offered as collateral for a business loan or an operating line of credit. As explained in the segment on equity, this is not supposed to be a text book course, but explains briefly what you will encounter in the real world of business finance.

These comments are not for the retail business; they apply to wholesalers, importers and manufacturers.

The amount of money the financial institution will be prepared to lend you will depend a great deal on the amount and ease of realization of the inventory collateral you can offer to cover the loan, in case there is a default in repayment.

It is not just the amount of the collateral, but the quality of the collateral, and whether it would realize enough to repay the loan if there was a liquidation of the business.

A typical example might be that your main collateral for a $1 million loan application is your inventory of widgets. The widgets will cost you $1,250,000 and you expect to sell them for a total of $2,000,000 which would gain you a $750,000 profit.

You would think your bank would be pleased to approve the loan.

These are some evaluation techniques related to the inventory that the bank will utilize before the credit approval decision can be made:

• Quality of the widgets: What percentage, if any, are damaged and non-saleable? Are they a seasonal item and, if so, are they carried over from the last season, or are they current? Are they a basic necessity or a gimmick that may not last? Are they easily saleable?
• What would be a reasonable liquidation value of the inventory, after auction and liquidation expenses? Is there a ready market for them? Will one have to store them at an expense, and attempt to sell them in the next season? Would the liquidation value cover the loan? Would the bank have to incur any expenses to render the inventory saleable? Will custom duties have to be paid before the inventory is released from bond, in the case of importers?
• What percentage of your existing inventory, if any, is covered by customer orders? Or is it purchased on speculation, in the expectation that orders will come in?
• When was the last physical count done of the inventory? Was the count supervised by the auditors? Is the dollar value based on GAAP ? (generally accepted accounting principles)
• Depending on the nature of the widgets, how often does the inventory turn over each year. Is it comparable to the industry average?

It is unusual for a bank to finance more than fifty percent of the cost value of inventory, because of the risks involved.

However, if you are an importer and you require the bank to open letters of credit for your suppliers, the bank may provide higher financing if you can show that a substantial portion of the inventory being bought is against customers’ purchase orders. Your borrowings, as shown in your cashflow projections, should also be within the line of credit approved for your business. Always keep in mind, when making your credit application, that bankers hate surprises! Give them all the information they need to make a credit decision upfront. If there is any negative aspect, bring it up and explain how you plan to deal with it.

Additional segments will deal with collateral other than inventory, as well as other aspects of commercial finance you will find useful to know.