Tuesday, May 19, 2009
At a very high level inventory is either tangible or intangible with a finite shelf life. By way of an example a grocery store has tangible assets (food) that has a finite life (expiration date). Equally, a building a supply store has a tangible asset in marble floor tiles, which have a finite life. Yes, marble floor tiles have a finite life! Once market demands move away from marble floor tiles, their ‘life’ or value has diminished or expired. On a more theoretical perspective of inventory; accountants, attorneys, engineers represent intangible inventory. Hiring an associate, affords the organization with a potential inventory (hours per day) which can be sold. Once those hours have gone by and not billed, their life or value has expired.
This contribution is not meant to expound on the virtues of asset management as there are countless contributions on: TQM, Kaizen modeling, Six Sigma, Lean manufacturing and the like. With this contribution, I am only hoping to demonstrate the many values of an organization’s inventory and how the asset can quickly become a liability. Very simply, the diligent management of inventory; the movement of inventory to sales, is the very essence on which profitability is built. Organizations that can move inventory at a higher price than acquired easily demonstrate higher gross margins.
To continue from the previous contribution, ABC ltd. is securing its operating line with inventory and receivables. To the financing institute these entities are current assets. However, ABC is limited in receiving the full value of these assets. In restating the covenant, ABC is advanced based on 50% of the acquired costs of the inventory, valued using FIFO, excluding inventory in excess of 120 days.
If ABC were to dissect this covenant they could easily unleash hidden value in their inventory. The financier is excluding all inventories in excess of 120 days. Basically they are taking the position, if the inventory is that old it has lost its merchantability. This is similar to a grocery store with two week old lettuce or a retail store with winter coats remaining in July. To ABC, this inventory has $75,000 in value – to the rest of the world it has no value and $75,000 in cost. It has become an asset of no value – a liability! It is weighing down its borrowing base!
For ABC, this inventory has no value and is tying up capital. However, depending on the type of inventory they may be able to unleash some hidden value. If this inventory is made up of computer hardware, they could bulk-sell the inventory for anything between $0 and $75,000 and thereby gain immediate cash. This would immediately positively impact their borrowing potential from their financier. It would be toward ABC’s advantage to closely monitor its inventory and move out, at what ever price, those goods which will expire in the foreseeable future.
Some goods may have a long expiration or the organization isn’t faced with an age covenant on inventory, yet there still remains a cost of holding onto slow or defunct inventory. Recently, I had the opportunity of working with an electronics provider, who in order to gain a new customer, took 180,000 transformers it purchased from a competitor. This inventory was taken in to secure a new customer, however in doing so my client had this entire inventory – at no cost! As cases of this stuff sat in warehouses throughout the country, I had to lead them to the tremendous inherent value in this inventory and the tremendous cost they were incurring to keep it. There was no acquisition cost of this inventory, but it was taking up space in their warehouses, and was being insured under their policy. Although it had no ‘book’ cost, each day it cost them floor space. The potential value was tremendous – they could sell this inventory at what ever the market would bear! As it turned out, they converted this ‘valueless’ competition inventory for forty cents on the dollar and came away with approximately $100,000.
To ABC, the inventory valuation covenant provides a 50% valuation based on the FIFO method of valuation. FIFO or First in First Out, uses a perpetual inventory system which ensures that the cost of the inventory is most reflective of current market prices. The financing agent, however, only attributes 50% valuation to such inventory. This perceived restriction should be seen as a benefit. This should be a clear indication to management that using short-term, operating line funds isn’t a reasonable way to build up inventories. With rapid order to delivery, drop-ship, EOQ models, and the like there is no reason why organizations would need to build up inventory. The less amount of funds tied up with inventory is more funds to grow the organization.
There is tremendous value to be had in closely monitoring inventory. Organizations often stifle their potential by holding on to defunct, damaged or obsolete inventory. The single most important thing in managing inventory is to ‘move – it’. Moving inventory is acquiring it, and then moving it onto the end user as fast as possible.
It isn’t surprising that the current economic condition of the world has lead to some very progressive thought and actions on means of managing inventory. Aside from all of the technology employed in managing tangible inventory, several professional services organizations have moved to managing their intangible inventory. Emily Heller of The National Law Journal in her May 5, 2009 article, Downturn May have an Upside for Contract Attorneys, explains how many law firms are simply shopping on a per need basis, for specific legal talent. Lisa Solomon of Ardsley, NY has been operating as a ‘hired-gun’ since 1996. Solomon says “business is growing, there is a demand.”
The current economic climate may be the Ice Age of the 21st century which radically shapes professional services organizations into streamlined brokerage houses for ‘hired-gun’ talent. To the professional, this provides a strong motivation to be the best and at the same time, rewards of diverse engagements, possibly far greater than those possible at a single firm.
Inventory is all around, in every organization. With each passing minute some of its value is diminishing. It is no wonder that modern day ‘inventory’ comes from the Latin word Invenire – to find. There is value in all inventories, tangible and intangible. I urge you to find it, and use it for what it was intended – Sell it!
Sunday, May 03, 2009
A recent engagement galvanized for me, how many organizations fail to understand the valuable role that banks play in the success of their organization. As many would contend, I am a strong believer that managing financial resources is the key to business success and growth. Success in business can be boiled down to: selling a product or service for more than producing it, and the product or service must be desired in the marketplace. Within this realm there are a few defining rules; keep inventory to a minimum by regular timely/accurate billing, timely collection of outstanding debts and keep expenses in check. However in the course of business there are times when more funds are needed than those available, hence the importance of banks. Banks can play many roles in the life of a business: short term funds, long term funds even an equity interest. Regardless of the role, like any investor, the bank needs to see value.
Many years ago I had the opportunity to work with a person who inherited a company through familial succession, yet had no concept of running the business; beyond making coffee. Through our time together I impressed upon Daniel some of the foundations to maintaining and growing the business; one of which was the importance of a good relationship with the bank. It wasn’t until recently that I saw Daniel’s frantic frustrations with the bank manifest itself in others. The frustrations boiled down to these people wanting more money from the bank, while the bank wanted to see more value in the companies. With these companies, the banks provided an operating line of credit which was secured with assets, current assets.
As I continue to advise firms on financial management, I feel it is more important to present this topic on managing operating lines. In a subsequent contribution I will present techniques to unlock hidden value in current assets to gain enhance one’s operating line.
As a foundation, banks and investors provide funds to organizations based on known risk and expected return. The level of risk assumed by these funding bodies determines their desired rate of return. Essentially, how much must they be compensated to assume this level of risk? To mitigate some risk, depending on the investment, these bodies will seek some collateral. In the case of an operating line of credit, the collateral is made up those current assets which can be quickly liquidated. In the case of stock or angel investment, the collateral is the vision of management.
An operating line of credit is short term money; it is intended to bridge the gap in converting inventory to cash. I have written extensively on using the ‘right’ type of funding for the ‘right’ type of activity. With this said, the institution is providing access to funds as a means of bridging this gap. In an earlier contribution I explained that the rule of thumb on the amount of ‘bridging’ required is determined on how long it takes to be completely repaid. The rule is, one year.
In determining the amount of the operating line, the institution looks at the economic viability of the organization, its history, its management team and their vision. As a means of mitigating some of their risk, they seek collateral. The most common sources of collateral for an operating line are: accounts receivable, inventory (WIP), and cash. Institutions will extend funds based on the value of these assets. As a caveat to the agreement, the institutions will clarify the value they place on the assets presented. This is clearly outlined in the agreement at the inception of the relationship and emphasized throughout the relationship by way of timely reporting.
It is by way of this disconnect between the institution and the business that frustrations arise. By way of a simple example, it becomes clear how frustrations can arise. ABC Ltd is a local supplier of consumer products; they do not manufacture the goods for sale. They simply add value through combining products to produce a convenience offering. ABC is in a fixed demand niche with very little cyclical behavior and they are one of several suppliers in the area. Their profit margin on inventory is 30% and requires a significant amount of human intervention to get the product offering to market.
In negotiating an operating line of credit, ABC Ltd is made aware that there will be certain limitations on the amount the institution will advance. Some of the most common limitations are:
- Inventory: Inventory is valued at 50% using FIFO (First in First Out). All inventories older than 120 days are excluded from valuation.
- Receivables: Receivables are valued at 70% for all those who are not more than 90 days past normal due date. For ABC, whose terms are N30, the limit is 120 days.
i. Excess Delinquency: Where a single client has an amount of receivable in excess of 120 days which is at least 25% of the total due – the entire account has no value.
ii. Credits: All credits over 120 days are excluded from valuation
iii. Concentrations over 10%: Where a single client represents more than 10% of the total receivable their entire receivable has no value.
Depending on the industry some other limitations on valuation are: accounts with Government bodies, affiliates, foreign receivables and third party relationships. These limitations are set to mitigate the risk of not getting paid should the company fail to be a going concern. Should this occur the institution would enact immediate measure to recoup most of their advanced funding.
The ABC demographics:
Sales: $10M per year
Inventory: $500K average, $75K excess of 120 days
A/R: $750K, $100K beyond 120 days, excess delinquency $65K, $150K in client concentrations.
To the organization, they see $1,250K in value to which they are expecting an operating line equal that amount. However, to the institution the true liquidity of the assets is $647,500, about 52% of expectation! Therefore ABC Ltd is only eligible for $647,500 in operating line. On top of this the institution may further penalize ABC for its inherent risks by imposing a less than sterling interest rate for borrow.
Clearly there is a disconnect between what ABC sees as value and what the lending institution sees as value. Hence the opposing duality, ABC stifled needing more cash and the institution demanding more value.
In my next contribution I will explore actions which ABC Ltd can undertake reduce the suffocating hold which they are under and have a better working relationship with their lender.