Inventory Loans - Financial Management

Inventories are another commonly used form of collateral for secured short-term loans. They represent a flexible source of financing since additional funds can be obtained as the firm’s sales and inventories expand. Like receivables, many types of inventories are fairly liquid. Therefore, lenders consider them a desirable form of collateral. When judging whether a firm’s inventory would be suitable collateral for a loan, the primary considerations of the lender are the type, physical characteristics, identifiability, liquidity, and marketability of the inventory.

Cost of Factoring Receivables for

Firms hold three types of inventories: raw materials, work-in-process, and finished goods. Normally, only raw materials and finished goods are considered acceptable as security for a loan. The physical characteristic with which lenders are most concerned is the item’s perishability. Inventory subject to significant physical deterioration over time is usually not suitable as collateral.

Inventory items also should be easily identifiable by means of serial numbers or inventory control numbers; this helps protect the lender against possible fraud and also aids the lender in establishing a valid title claim to the collateral if the borrower becomes insolvent and defaults on the loan. The ease with which the inventory can be liquidated and the stability of its market price are other important considerations. In the event that the borrower defaults, the lender wants to be able to take possession, sell the collateral, and recover the full amount owed with minimal expense and difficulty.

Both commercial banks and asset-based lenders make inventory loans. The percentage of funds that the lender will advance against the inventory’s book value ranges from about 50 to 80 percent and depends on the inventory’s characteristics. Advances near the upper end of this range are normally made only for inventories that are standardized, nonperishable, easily identified, and readily marketable. To receive an inventory loan, the borrower must sign both a promissory note and a security agreement describing the inventory that will serve as collateral.

In making a loan secured with inventories, the lender can either allow the borrower to hold the collateral or require that it be held by a third party. If the borrower holds the collateral, the loan may be made under a floating lien or trust receipt arrangement. If a third party is employed to hold the collateral, either a terminal warehouse or a field warehouse financing arrangement can be used.

Floating Liens

Under a floating lien arrangement, the lender receives a security interest or general claim on all of the firm’s inventory; this may include both present and future inventory. This type of agreement is often employed when the average value of the inventory items is small, the inventory turns over frequently, or both. Specific items are not identified. Thus, a floating lien does not offer the lender much protection against losses from fraud or bankruptcy. As a result, most lenders will not advance a very high percentage of funds against the book value of the borrower’s inventory.

Trust Receipts

A trust receipt is a security agreement under which the firm holds the inventory and proceeds from the sale in trust for the lender.Whenever a portion of the inventory is sold, the firm is required to immediately forward the proceeds to the lender; these are then used to reduce the loan balance.

Some companies engage in inventory financing on a continuing basis. In these cases, a new security agreement is drawn up periodically, and the lender advances the company additional funds using recently purchased inventories as collateral. All inventory items under a trust receipt arrangement must be readily identified by serial number or inventory code number. The lender makes periodic, unannounced inspections of the inventory to make sure that the firm has the collateral and has not withheld payment for inventory that has been sold.

Businesses that must have their inventories available for sale on their premises, such as automobile and appliance dealers, frequently engage in trust receipt financing, also known as floor planning. Many “captive” finance companies that are subsidiaries of manufacturers, such as General Motors Acceptance Corporation (GMAC), engage in floor planning for their dealers.

Terminal Warehouse and Field Warehouse

Financing Arrangements

Under a terminal warehouse financing arrangement, the inventory being used as loan collateral is stored in a bonded warehouse operated by a public warehousing company. When the inventory is delivered to the warehouse, the warehouse company issues a warehouse receipt listing the specific items received by serial or lot number. The warehouse receipt is forwarded to the lender, who then advances funds to the borrower. Holding the warehouse receipt gives the lender a security interest in the inventory. Because the warehouse company will release the stored inventory to the firm only when authorized to do so by the holder of the warehouse receipt, the lender is able to exercise control over the collateral. As the firm repays the loan, the lender authorizes the warehouse company to release appropriate amounts of the inventory to the firm.

Under a field warehouse financing agreement, the inventory that serves as collateral for a loan is segregated from the firm’s other inventory and stored on its premises under the control of a field warehouse company. The field warehouse company issues a warehouse receipt, and the lender advances funds to the firm. The field warehouse releases inventoryto the firm only when authorized to do so by the lender. Although terminal warehouse and field warehouse financing arrangements provide the lender with more control over the collateral than it has when the borrower holds the inventory, fraud or negligence on the part of the warehouse company can result in losses for the lender.

The fees charged by the warehouse company make this type of financing more expensive than floating lien or trust receipt loans. In a terminal warehouse arrangement, the firm incurs storage charges, in addition to fees for transporting the inventory to and from the public warehouse. In a field warehouse arrangement, the firm normally has to pay an installation charge, a fixed operating charge based on the overall size of the warehousing operation, and a monthly storage charge based on the value of the inventory in the field warehouse.

Overall warehousing fees are generally 1 to 3 percent of the inventory value. The total cost of an inventory loan includes the service fee charged by the lender and the warehousing fee charged by the warehousing company, plus the interest on the funds advanced by the lender. Any internal savings in inventory handling and storage costs that result when the inventory is held by a warehouse company are deducted in computing the cost of the loan.

INTERNATIONAL ISSUES

Foreign Receivables Financinga

Small- and medium-size U.S. businesses that sell on credit to customers in foreign countries are faced with additional problems in obtaining loans on these receivables. Because of low profit margins and unfamiliarity with international markets, bank financing of these receivables is often difficult. For example, if a commercial bank does advance funds on the foreign receivables, it may want the seller to use its U.S. assets as additional collateral for the loan.

Alternatively, factors will finance foreign receivables that are insured by the Export-Import Bank.The factor will advance about 85 percent of the amount of the receivables and then remit the remainder, less fees of 1.5 to 3 percent, after the foreign customer’s payment is received. Another alternative source of receivables financing is a forfait company, such as London Forfaiting, which will advance funds to the seller before they collect from the buyer. Forfaiters usually want the sales contract guaranteed by a foreign bank or government. Finally, a trading company can be used to obtain financing. The trading company will take title to the goods and arrange shipment to the foreign buyer. Such companies work with sales contracts that are guaranteed or insured by programs of U.S. and foreign governments.

Generally,U.S.exporters that require receivables financing should expect to pay in the range of 2 to 3 percent of the amount of the transaction. a See Bill Holstein,“Exporting: Congratulations Exporter! Now About Getting Paid . . .” Business Week (January 17, 1994): 98. tory, fraud or negligence on the part of the warehouse company can result in losses for the lender. The fees charged by the warehouse company make this type of financing more expensive than floating lien or trust receipt loans. In a terminal warehouse arrangement, the firm incurs storage charges, in addition to fees for transporting the inventory to and from the public warehouse.

In a field warehouse arrangement, the firm normally has to pay an installation charge, a fixed operating charge based on the overall size of the warehousing operation, and a monthly storage charge based on the value of the inventory in the field warehouse. Overall warehousing fees are generally 1 to 3 percent of the inventory value. The total cost of an inventory loan includes the service fee charged by the lender and the warehousing fee charged by the warehousing company, plus the interest on the funds advanced by the lender. Any internal savings in inventory handling and storage costs that result when the inventory is held by a warehouse company are deducted in computing the cost of the loan.


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