Jeff Judy

Jeff's Thoughts - August 31 , 2011

The Perils of Inventory

For this issue of Jeff's Thoughts, I have asked my good friend and colleague Charlie Dickerson to give us a closer look at the practical challenges of dealing with collateral. In Charlie's decades of experience in banking, he's seen just about everything. In this article, he uses inventory to show us why collateral is not nearly as simple as it seems, sometimes, when we sign the documents. More about Charlie below.

You've wanted this piece of business for some time , and finally the company President runs into you on the street corner outside the bank. From this chance encounter, a date to "talk business" is set.

There have been rumors for some time that the prospect hasn't been getting along with its bank, but your only regular contact with corporate management has been while serving with the Chairman on the local Industrial Development Authority and that acquaintance has unfortunately only been of the "quarterly handshake" variety.

But you've been listening more carefully since your recent meeting. Word gets around in a community like yours and what you've heard is that the company is experiencing a surge in business that from developing a new line of electronic instruments for industrial use, derived from controls the company has sold to household products manufacturers for many years.

Your discussion goes well and eventually gets down to specifics. At the end, your slant on things is that some credit secured by the company's inventory might be the solution to its near-term problems.

You let your mind drift back to when the bank was considering floor-planning one of the local automobile dealerships. Even though you thought the owner was trustworthy, your good judgment kept telling you that occasional spot-checking of your collateral was essential. You felt the need to be reassured occasionallythat your collateral was still on the premises! You'll have to hire someone like that again.

And keep this in mind, too. You've never seen one of these new devices. Could it possibly be carried out of our prospect's plant in a lunch bucket or a tool box? You've got to make sure from time to time that your collateral exists. Peril #1 with this type of lending -- inventory can disappear!

Fortunately for you, Peril #2 is not likely to apply in your case. But it can't be overlooked in others. Peril #2 is that some types of inventory can deteriorate. Be glad you aren't considering a line of credit against frozen foods!

You were smart when the company's Vice President for Manufacturing took you through the production line because you specifically kept in mind Peril #3. The more intricacies there are in the production process, the higher the chance a certain percentage of your collateral could become damaged. You'll have to allow for that!

And the manufacturing process might not be the principal damage source, either. Ask to see where inventory is stored awaiting shipment. Does the storage area look like a war zone? Does there appear to be no sense of order in there? If the borrower can't tell you what's in storage or exactly where to find it, how can they expect to lay your hands on it, if you decide to sell it yourself?

Peril #4 probably won't be applicable to the present situation, but it can be disastrous if it does apply and the lender misses it - and that is seasonality. Ask anybody who finances Christmas items or nursery stock how uncomfortable it is to carry as collateral something that temporarily has little or no value!

There are many smart professionals in this field and even they regularly get stung. After listing all the perils of taking inventory as collateral, it would not be surprising if you decide the risks far exceed the rewards with this type of lending.

There are other factors that we haven't mentioned yet. People scour the streets for some of the internal components of instruments like these -- copper wire, for instance -- which could ruin it as collateral for you. And what if your collateral must be stored outside after you take possession. Forget for a moment about the weather itself. Will fencing be required? Lighting? Guards? The potential cost mounts!

Are you sure your legal documents are sufficient? How long has it been since your counsel has reviewed them? Do you carry proper and sufficient insurance?

We don't espouse walking away completely from taking inventory as collateral. But we do suggest that, if you are not fully aware of the difficulties of lending against inventory, you may want to think twice about the risks involved.

About Charlie Dickerson

Charlie Dickerson began in commercial banking in Pittsburgh after graduating from Dartmouth College. Later he moved to Philadelphia to work for the First Pennsylvania Banking and Trust Company. While at First Pennsylvania, he managed the Credit Department and supervised the bank's Management Training Program. Later, he was active in the Loan Review and Correspondent Banking Departments. After leaving First Pennsylvania, he became responsible for all lending activities for two smaller banks in neighboring states. Charlie was also President of Crossing Financial Consultants for many years and has taught for major trade groups, state banking associations, and CPA firms.