Inventory

What does it mean

Inventory describes the total value of inputs on hand at a company that contribute into the final product sold by the business.  Inventory is generally broken into three main categories:

1. Raw Materials
2. Work in Process (WIP)
3. Finished Goods

Why does it matter

Understanding inventory factors into a few areas of knowing your borrower.  The first reason is that understanding the inventory of the business helps you to understanding the operating cycle of the business which helps you identify potential risks present for that business.  The second reason is from an efficiency standpoint.  Knowing the appropriate amount of inventory for a business can be difficult.  One indicator to help know how much inventory is appropriate for a business is to look at the Inventory Turnover Ratio.  These ratios show the amount of inventory in relationship to the amount of revenue a business has.  All things equal, a business with more revenue will have more inventory on hand.  Comparing a customer’s ratios to RMA averages can give you some context to know if a customer has too much or too little inventory.  

Likely, inventory is a major component of the balance sheet, and by knowing the peer averages, a company may be able to free up some capital by reducing inventory on hand as long as they can increase their inventory management skills.  

The last reason to be aware of inventory is that for operating debt, it is typically your collateral.  Inventory is a quick moving asset; so keeping tabs on inventory levels will be key especially if the business either does not have additional equity/collateral elsewhere or if the business is operating at a loss which is causing them to eat into their overall working capital position and deteriorating your collateral position.  Specifically from a collateral perspective, knowing the breakdown of inventory between Raw Material, Work in Process (WIP) or Finished Goods is important.  The main reason is that Work in Process inventory has considerably less collateral value than the other two, and the reason makes sense.  It is tougher to find someone to buy a half-build widget than it is for someone to purchase the raw plastic (raw material) or shelf ready item (finished goods).  Due to this difference, it is typical for Work in Process to receive a lower advance rate in a Collateral Analysis or Borrowing Base Certificate.

Other Relevant Terms

• Capital
• Current Assets
• Current Liabilities
• Raw Material
• Work in Process
• Finished Goods
• Borrowing Base Certificate
• Equity
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