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Reprinted from the January 2005 Issue, Vol. 3, No. 1

Evaluating Inventory: Risks of Relying on Financial Statement Level Analysis

Lenders should be careful not to rely heavily on financial statement level information to assess the health of the inventory. Requesting and analyzing category and item level inventory and sales information allows the lender to get a better grasp of the inventory either being considered for collateral or already part of an existing borrowing base. By Park Johnson and Navin Nagrani

I

n evaluating inventory for collateral lending purposes, ratio calculations, such as inventory turnover and days sales in inventory (DSI), are frequently used. The use of these ratios is based upon the presumption that the historical demand for inventory that is exhibited during the normal course of business is an accurate tool in predicting the demand for similar items of inventory during a liquidation sale. A net orderly liquidation value (OLV), also referred to as a liquidation sale, is the most common premise of value that is used for asset-based lending that involves inventory. There is significant risk to a lender in relying solely on analysis performed at a financial statement level. Depending on the mix of inventory, a lender may extend credit beyond the ability of the collateral to support it, or may offer lending terms that are so conservative that potential borrowers may consider competing lenders.

Example 1

This first example involves a distributor of products, such as pens. All inventory can be classified as finished goods. The distributor stocks and sells fountain pens and has ballpoint pens sent directly from its vendor to its customers (known as drop shipments). The average stocked inventory, by category, is: Ballpoint Pens Fountain Pens Total Stocked Inventory $ $ $ 0 500,000 500,000

The total COGS for 12 months, by category, is: Ballpoint Pens $ $ $ 2,600,000 900,000 3,500,000

Inventory Turnover is defined as: 12 Months Cost of Goods Sold (COGS) / Average Inventory (AI)

Fountain Pens Total COGS

Using a ratio analysis at a total level, inventory turnover would be: Days Sales in Inventory (DSI) is defined as: 365 / Inventory Turnover DSI would be: 365 / 7.0 (Days) = 521 Days Inventory turnover is calculated by dividing the cost of one year's of goods sold (COGS) by the average inventory (AI) level at cost. Days Sales in Inventory (DSI) is taking the inventory turnover divided by 365. At a high level, these accounting ratios are useful in evaluating a company's ability to efficiently use assets, such as inventory. However, relying on these textbook ratios as a means for monitoring inventory that is used as collateral for a loan may be risky; this level of analysis may mistakenly characterize demand for inventory. Examples will be used to illustrate how a high level of analysis may not characterize demand and will indicate the level of analysis that should be performed in evaluating inventory for collateral lending purposes. DSI would be: 365 / 1.8 (Turns) = 202.8 Days When you look at the analysis from a high level, it appears as if there is slightly less than two months supply on hand. After a detailed evaluation, it is obvious that the actual stocked inventory represents a supply of more than six months. Inventory with a six-month supply on hand will recover at a much lower rate than inventory with a supply of two months. However, when the calculation is performed at a more detailed level, the turnover analysis shows a dramatically more accurate picture of the inventory on hand. The turnover for fountain pens would be: $900,000 (12 Months COGS) / $500,000 (AI) = 1.8 Turns $3.5 million (12 Months COGS) / $500,000 (AI) = 7.0 Turns

© 2005 ABF Journal, 409 East Lancaster Avenue Wayne, PA 19087. All rights reserved. Reproduction in whole or in part is not permitted without written permission.

While drop shipping is an extreme example, the analysis holds true for mixtures of rapidly moving and slowly moving inventory. Performing an analysis at a high level allows the sales of rapidly moving inventory to conceal the performance of slowly moving inventory. Evaluating inventory at an item level or even at a category level prevents this distortion. It should be remembered that rapidly moving inventory is frequently not present in great quantities because it is selling. Without proper purchasing procedures, slower moving inventory tends to accumulate because it is not selling.

The average finished goods inventory is: January ­ June July ­ December Yearly Average COGS would be: January ­ June July ­ December Total for the year $ $ $ 10,000,000 6,000,000 16,000,000 $ $ $ 1,000,000 3,000,000 2,000,000

Example 2

The second example compares the inventory turnover for an industrial manufacturing company that has an average of $10 million in inventory and $60 million in COGS for the year. The inventory consists of:

Using an average inventory of $2 million can either overstate or understate the turnover calculation, depending on the time of year. At an annual level, inventory turns would be: $16.0 million (12 Months COGS) / $2.0 million (AI) = 8.0 Turns DSI would be: 365 / 8.0 (Turns) = 45.6 Days

Raw Materials Work in Process (WIP) Finished Goods Total Inventory

$ $ $ $

4,000,000 2,000,000 4,000,000 10,000,000 Inventory turnover during the first half of the year would be: $20.0 million (6 Months of COGS, Annualized) / $1.0 million (AI) = 20.0 Turns DSI would be: 365 / 20.0 (Turns) = 18.3 Days In the second half of the year, inventory turnover would be: $12.0 million (6 Months of COGS, Annualized) / $3.0 million (AI) = 4.0 Turns DSI would be: 365 / 4.0 (Turns) = 91.3 Days If a liquidation sale were to occur in the second half of the year, it would be reasonable to assume that the inventory would take longer to sell than if the sale were to occur during the first half of the year, and therefore the net recovery would be less.

In using the formulas in this article, inventory turnover would be: $60 million (12 Months COGS) / $10 million (AI) = 6.0 Turns DSI would be: 365 / 6.0 (Turns) = 60.8 Days The high level calculation here ignores the fact that it is only finished goods that are normally sold through existing sales channels. In the normal course of business, raw materials and WIP are converted into finished goods for sale. Under the most common definition of a liquidation sale, production ceases and raw materials and WIP would be sold as is in their current state. Turns should be calculated only for finished goods. If the calculation were based upon average finished goods only, the turnover would be: $60 million (12 Months COGS) / $4 million (AI) = 15.0 Turns DSI would be: 365 / 15.0 (Turns) = 24.3 Days This turnover calculation shows that finished goods are actually turning more quickly than the high-level analysis indicates. This is a more accurate indicator of the performance of the finished goods. The need to evaluate finished goods inventory separately is especially important when raw materials and/or WIP represent a significant portion of the inventory. Other approaches would be needed to assess the value of those assets, as raw materials and WIP are not sold through existing sales channels.

Conclusion

Lenders should be careful not to rely heavily on financial statement level information to assess the health of the inventory. Requesting and analyzing category and item level inventory and sales information allows the lender to get a better grasp of the inventory either being considered for collateral or already part of an existing borrowing base.

Park Johnson is a senior appraiser with Hilco Appraisal Services in its Industrial Inventory Practice. He has conducted more than 80 appraisals in a wide variety of industries. Navin Nagrani is a senior financial analyst and team leader in Hilco Appraisal Services' Industrial Inventory Practice. Hilco Appraisal Services provides a full spectrum of business asset appraisals for lenders, equity sponsors, investment bankers and corporate clients covering every asset class.

Example 3

This third example shows the effects of seasonality on turnover analysis. This company manufactures widgets. In this scenario, widgets are a highly seasonal item. The majority of the company's sales occur during the first half of the year, as customers prepare to incorporate the widgets into their end products. Widgets also take a long time to manufacture. Manufacturing takes place during the second half of the year, as inventories are built up to support sales in the following first half of the year.

© 2005 ABF Journal, 409 East Lancaster Avenue Wayne, PA 19087. All rights reserved. Reproduction in whole or in part is not permitted without written permission.

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