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The Slippery Slope, Part Three

  
  
  

A Proactive Approach to Protecting Collateral Values

In Part 1 of this article, we reviewed the business dynamic that leads to erosion in collateral values when a retailer with an asset based loan backed by inventory experiences an unplanned sales decrease. We demonstrated that the cause is directly related to how management responds to that decrease, and the fact that, invariably, when sales begin to slip, inventory levels don't decline at the same rate.

In Part 2, we laid out the case for early intervention as soon as a retailer experiences an unplanned sales decrease, to provide management with an independent, factual assessment of the situation and a comprehensive plan of action, to be taken at the moment of greatest financial strength and market position, before any further erosion takes place, and finally, to provide both the retailer and the lender the best opportunity for protecting and maintaining collateral values.

A Proactive Approach

All of this is critically important when a retailer hits a bump in the road, but early intervention in the event of an unplanned sales decrease remains a reactive step. While it provides both the retailer and the lender the best opportunity for protecting and maintaining collateral values, it is not a proactive approach. A proactive approach requires an assessment of the retailer's ability to effectively manage its inventory and react to potential changes in demand prior to any decreases actually occurring. And the time for that proactive assessment is at the point of loan origination.

Another way to think of this is to consider the due diligence process that currently takes place at origination. This includes the lender's internal review of company financials and fundamentals, including detailed discussions with management, as well as external, independent field audits and inventory appraisals.

Implicit in this process is that the collateral value of the loan is a direct function of the company's ability to manage its inventory effectively. And yet, the inventory appraisal function is limited in its scope, by definition, to a liquidator's financial model of the net liquidation value at that point in time. And the field audit is limited to a testing of the inventory records and financial valuation. What's missing is an assessment of the company's ability to manage its inventory effectively, its ability to respond quickly to changes in market demand.

Why an Inventory Management Assessment?

Why is this important to the lender? What additional information would such an evaluation provide to the lender, and most importantly, what would the lender do with this information.

1. An inventory management assessment would provide the lender with the insight to develop covenants around critical inventory metrics in addition to financial metrics. When retailers collateralize their inventory, their cash management objective becomes maximizing the availability on the loan. Inventory is perceived not as an item on the balance sheet that's tying up cash, but rather a source of cash, despite the fact that a reduction in inventory will generally yield cash flow significantly in excess of the advance rate. Because of these competing incentives, inventory management metrics often begin to slide, regardless of the sales trend. Building covenants around inventory metrics serves to reinforce the importance of maintaining, and improving upon, effective inventory management practices. An inventory management assessment would call out the key metrics to be monitored and the reporting necessary to monitor these metrics.

2. An inventory management assessment would provide the retailer with an independent perspective on opportunities for improving their inventory management practices, in an environment more conducive to constructive dialogue than would be possible during the comparative crisis of declining collateral values and advance rates. An inventory management assessment would provide the retailer with specific recommendations for improving their inventory management practices, and thus, protecting the collateral value of their inventory.

3.  An inventory management assessment would provide the lender with a critical insight into potential collateral risk, risk that is not otherwise clear from a lender's internal review or from a field audit or inventory appraisal. If a retailer has had a mixed revenue history, and has struggled to respond quickly and effectively in the past to keep inventories in line, the lender is assuming greater collateral risk than a retailer with a similar sales history who has demonstrated the ability to respond quickly to changing sales trends.

4. An inventory management assessment would provide the lender with critical information that would reduce the odds of the prospective loan eventually ending up in workout.

What are the critical metrics?

1. Actual Sales versus Planned Sales - Demand forecast accuracy is the starting point to sound inventory management. A process for evaluating the accuracy of sales forecasts on an on-going basis is essential, both to adjust forward sales plans at the earliest possible moment, as well as for improving the overall quality of the forecasts.

2. Actual Ending Inventory versus Planned Ending Inventory - Comparing actual ending inventory versus planned ending inventory is a quick measure of how effective the retailer is in managing its inventory investment. When actual inventory levels begin to exceed planned inventory levels immediate action is required to bring inventories back into line to protect the value of the inventory investment.

3. Actual Monthly Receipts versus Planned Monthly Receipts - Comparing actual monthly receipts versus planned monthly receipts is a measure of how well a retailer is able to manage its supply chain, as sales and inventory plans are adjusted. In the event of a decline in the sales trend, a company which has built a flexible, collaborative and responsive supply chain, and has demonstrated the ability to manage it effectively, is well positioned to be able to bring inventories into line quickly.

4. Forward Weeks of Supply - Forward weeks of supply is a point-in-time metric that is the key tool for assuring that inventory is in line with planned sales. Comparing planned forward weeks of supply with actual forward weeks of supply measures the retailer's ability to keep inventory levels in line with demand.

5. Obsolete/Aged Inventory Analysis - Actual Forward Weeks of Supply can be significantly impacted if there is an underlying body of obsolete and/or aged inventory on hand. When it can be identified, obsolete and/or aged inventory is almost always excluded on the borrowing base, and the change in value tracked as time goes along. From an inventory management perspective, however, what is particularly instructive is whether this inventory is static, merely requiring focus and attention to liquidate it, or dynamic, in that it is being liquidated on the one hand, only to be "replenished" on the other with "new" aged and/or obsolete inventory.

6. Cumulative Markdown Rate - In order to minimize the build-up of obsolete inventory, it is imperative that markdowns be taken on a timely basis. Where excessive markdowns might suggest problems associated with up-front demand planning, insufficient markdowns, on the other hand, frequently leads to the build-up of obsolete and aged inventory.

7. Customer Service Level Analysis - For distributors and catalog and ecommerce retailers the key customer service metric is initial fill rate. For traditional retailers the comparable metric is the in stock rate. These metrics measure how effectively the retailer is meeting immediate customer demand, and converting that demand into revenue.

Potential Objections

It is important to clearly understand a retailer's potential objections to an Inventory Management Assessment as a part of the due diligence process. Clearly, despite the compelling desire to obtain financing, most retailers are nevertheless resistant to field audits and inventory appraisals. These are viewed as a necessary but intrusive and time consuming part of the financing process. It can be argued that an Inventory Management Assessment would be no less intrusive or time consuming, and management might argue that it would infringe even more on what they perceive as their prerogative to manage their business than either a field audit or an inventory appraisal.

The response is that experience has taught that when collateral values begin to slip nobody is a winner. Frequently, management feels as though they've been blind sided when their advance rate is reduced, and not just because they may not necessarily understand the nuances of the inventory appraisal model. It's almost as if they feel the rules of the game have been changed on them in midstream, for no other reason than that they've had a down month or a down quarter. This is very understandable, for most likely they've been dealing with an inconsistent sales trend for a while, long before the asset based loan was in place. Dealing with these ups and downs has become, in their minds, an integral part of managing the business, which they thought everybody understood upfront, and which hasn't inherently changed the collateral value of the inventory.  

Conclusion

The critical benefit that both lender and borrower derive from an Inventory Management Assessment at loan origination is that the borrower has clearly reinforced in their minds the direct link between their ability to manage their inventory effectively, perhaps more effectively than they ever have in the past, and the maintenance of the collateral value and their advance rate. And that's good for both the lender and the borrower. In this way, an Inventory Management Assessment becomes a Win/Win proposition for everybody concerned.

 

© Ted Hurlbut 2004

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