Note: This article is excerpted but was published in its entirety in the March 2008 edition of the ABF Journal
When companies start to face financial trouble, many begin selling their best inventory at slightly discounted prices in order to generate additional revenue. Small incentives are offered in an effort to incentivize the purchase of additional products. Selling prime inventory in this fashion is an attractive option to troubled companies because it is a short-term solution that is simple, effective and on its surface, not a cause for alarm.
However, inventory sell-offs begin to unfavorably alter the mix of the inventory. Prime inventory is sold, leaving an inventory that is likely less in demand, slower moving, and typically, less valuable. As a result, if a liquidation of the inventory did become necessary the inventory that generates the best recovery value may be reduced or gone. The issue is even more severe in situations where the overall value of an entire inventory is driven by a small amount of prime inventory.
Monitoring for this can be difficult because the sell-off can occur quickly and quietly. If a company becomes financially distressed, it is important to increase the frequency of collateral monitoring.
A critical measurement in gauging the liquidation value of an inventory is determining who will buy the inventory and what they will pay for it. The two most common liquidation channels of an inventory are to a company's existing customers and to secondary buyers (such as competitors, brokers or scrap dealers). The customer channel normally has the highest recovery value while secondary channels are typically lower. Understanding and monitoring the amount of inventory expected to sell to each avenue is critical.
There are indicators that can be monitored so that a lender can understand if what would be expected to sell to customers versus others has shifted. If a shift occurs, it is likely the appraised recovery rate has changed considerably. As these levels are monitored, the question should be asked if the liquidation scenario outlined in the appraisal is consistent with the lender's internal guidelines. Clearly the appraisal scenario needs to match the temperament of the lending institution regarding risk and how they would actually run a liquidation for the appraisal conclusions to be meaningful.
Lending arrangements secured by inventory require close consideration to what would happen if the subject company became distressed. The typical liquidation scenario assumes a distressed company, although a commonly overlooked consideration is the health of the company's industry. This is significant because the success of a liquidation can be drastically different depending on the condition of the industry.
If a company had to liquidate its inventory in a healthy industry where its customers and competitors are financially solid, there is typically a good chance that industry participants will be interested in the inventory and have the financial means necessary to make the purchases. Whereas, if a company had to liquidate its inventory in a weakening or crippled industry, it is usually more probable that industry participants will be less interested or not have the financial means necessary to purchase inventory. Even if the inventory is still attractive in an unhealthy industry, it may have to be sold outside of traditional disposition avenues. While there are exceptions, if there is less demand, less potential purchasers or non-traditional disposition avenues used, it is more difficult to sell the inventory and it will likely generate lower recovery values.
Lenders should understand the condition of the industry they compete in and monitor publications, websites and market studies on a routine basis. Frequent discussions with Management and other industry participants can shed additionally light on the health of the respective industry. It is critical for lenders to know whether the effective date of the most recent inventory appraisal or other market studies occurred during a healthy or unhealthy time in the industry. If the condition of the industry is changing, an update appraisal should be conducted.
Drop shipments are when a company orders product from a vendor and it is shipped directly from the vendor to the customer. This results in a sale without the company taking possession or ownership of the inventory. While a popular and effective distribution model, it is important to understand what it means relative to collateralized inventory. Specifically, if a company starts to drop ship product, or if the amount of drop shipments significantly increases, it is important for lenders to know whether the existing inventory is still selling normally or if it is becoming stagnant.
The concern is that if desirable products are being drop shipped, the inventory physically in possession by a company can become slow moving, aged, less attractive, or even obsolete. The inventory can be negatively impacted while sales and gross margins remain stable, or even improve. If this occurs, the inventory may become substantially less attractive, impacting its value as collateral.
Lenders should routinely request clients to report the amount of sales derived from drop shipments so the trend can be monitored over time. Significant events such as the movement of manufacturing overseas, key vendor changes, or new product introductions should prompt a lender to ask whether drop shipments have started or increased.