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Banking – Inventory Collateral

Operating Lines of Credit and Letters of Credit



 

We highly recommend that, if you have not already done so, you read the first article in this series, Banking – Business Loan Application, at :
http://www.youngagainforever.com/banking_business_loan_application.html

Everything explained in this article on inventory collateral financing will then fall into place naturally.

As in the other articles in this series on fundamental principles of business banking, we wish to clarify the following facts:

This is not intended to be a detailed accounting or banking course. I have put together the essential information you need in order to give yourself the best chance of succeeding in your business. I shall tell you what your bank manager would like to hear from you at your meetings. I shall tell you the early warning signs that your business needs positive action.

These comments are not for retail business finance, or personal loans; they apply to wholesalers, importers and manufacturers.

To cover the vast amount of banking information, even in thumbnail format, I shall break it down into various segments. Some will apply to your business, others may not. I am intentionally phrasing the segments in very simple layman’s terms. I would advise you to discuss my advice with your accountant, or even your banker, before you decide to act on it.

Let us assume that you make an application to a bank, or other financial institution, for an operating line of credit for your business.

As explained elsewhere in this series on business bank loans, the potential lender will examine various important aspects of the business in order to assess, among other things, the following:

• The viability of the business

• The profitability of the business

• The track record of the business

• The credit history of the business

• The credit history of the owners

• The quality of the collateral

• The adequacy of the collateral

The collateral to cover the operating line of credit usually comprises the following:

• Accounts receivable

• Inventory

• Personal guarantees of the owners

• A floating charge covering any other unencumbered assets

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.

The amount of money the financial institution will be prepared to lend you against inventory, will depend a great deal on the 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 dollar book value 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 is the history of returned merchandise? For what reasons?

• 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 customs duty 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?
~ Has the stock been purchased against orders?
~ Or is it purchased on speculation, in expectation of orders to 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 perceived 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 temporarily if you can show that a substantial portion of the inventory being bought is against customers’ purchase orders. Once the inventory arrives and is shipped within a short time to customers, the loan is then covered by the new accounts receivable generated, and the risk factor, as far as the bank is concerned, is reduced.

Your borrowings, as shown in your cashflow projections, should also be within the line of credit approved for your business. If the loan is going to temporarily peak beyond the line of credit approved, be sure to explain that to the bank. Point out the reason why, and how it will be adequately covered by collateral. Banks hate surprises, unless they are of a positive nature. The last thing you want is for the bank to refuse to cover cheques you have issued for business expenses.

So, give them all the information they need upfront to make a credit decision. If there is any negative aspect, bring it up and explain how you plan to deal with it.

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

Other segments on business banking cover:

Equity in the business

Accounts Receivable Collateral
>Inventory Collateral
Letters of Credit
Cashflow projections
Banking - Business Loan Applications


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