Loan or Advance against Inventory is financing provided to a buyer or seller involved in a supply chain for the holding or warehousing of goods (either pre-sold, un-sold, or hedged) and over which the finance provider usually takes a security interest or assignment of rights and exercises a measure of control.
Loan or Advance against Inventory
- Inventory Finance
- Warehouse Finance
- Financing against Warehouse Receipts
- Floor Plan Finance
Loans or Advances against Inventory may be used at any stage and by any party in a supply chain acting as seller and/or a buyer. The incidence of the financing need will depend on the structure and timing of the manufacturing and delivery cycles deployed along a particular supply chain. Inventory financing is typically confined to qualifying marketable commodities (e.g. raw materials such as minerals, metals and agricultural products) for which a value can be readily ascertained, and to finished goods or work in progress where a potential buyer may have already been identified and for which a contract to purchase or a purchase order may have already been issued; the requirement to identify a buyer or have a contract or purchase order in place recognises the potential lack of marketability of finished goods or work in progress.
The financing is usually arranged as a loan or advance against the inventory, although variations described below provide alternatives. The tenor of transactions will be short term and advances are usually made under a committed or uncommitted facility with an annual review.
For the financing of finished goods and work in progress, reference is made to the definition of Pre-shipment Finance (see separate SCF technique definition). The finance of goods in transit such as on-board a vessel or by air may also be included.
For some market participants, loans against inventory in the setting of SCF necessarily involve a seller and a buyer in a structured relationship as part of a particular supply chain. For the purposes of this standard market definition a wider view has been taken to include all types of inventory finance.
A typical Loan or Advance against Inventory transaction involves two main parties: the client or borrower (which could be a seller or buyer, as noted earlier) and the finance provider. A third party warehouse may also be involved, which could be certified or recognised by governmental or trade bodies, and in which the existence and condition of stored inventory is continuously monitored by a reputable third party and/or by the finance provider itself. The goods may also be stored in a location under the direct control of the finance provider or on the borrower’s own premises.
Contractual relationships and documentation
The borrower and finance provider enter into a financing agreement and a security agreement covering title to the underlying inventory and covering warehouse receipts (evidencing storage of the goods in the warehouse) where used. Ancillary agreements with a warehouse operator and third party collateral management or inspection agents may also be required.
The finance provider obtains title over the goods for the duration of the transaction and only releases title when the loan is repaid. Security will be obtained by means of delivery of negotiable warehouse receipts or warrants or an assignment of rights (or assignment of title such as a pledge) relevant to the location of the inventory and the specific jurisdiction concerned. Legal advice and opinions are an essential precaution in relation to any specific situation. In the case of goods in transit this may take the form of bills of lading, often consigned or endorsed to the finance provider. Other security perfection techniques may be employed depending on the relevant jurisdiction.
Risks and risk mitigation
- Difficulties experienced by the customer in disposing of the inventory in a timely fashion under a third party sale in order to generate repayment or an inability to refinance the inventory
- Quality or damage to the inventory mitigated by inspections and property and casualty insurance
- Ongoing business risks impacting the ability to repay
- An ability to re-possess and dispose of the relevant inventory in the event of the borrower becoming illiquid or insolvent. Having and retaining the necessary industry and product experience is a key risk for the finance provider
- The location of the inventory, for example, stored within an independent warehouse, or if on the borrower’s premises stored in a way that the goods can be easily identified and carefully controlled
- The intrinsic value and saleability of the inventory remains a continuing risk factor during the life of the transaction and this is influenced by the condition of the inventory, its importance to a critical manufacturing or sales process, market conditions, and logistics aspects in the event of the need to exercise the right to repossess and sell
- It is common to advance only a percentage of the value of the inventory so as to establish a margin of protection. For a situation where a number of lines of inventory are financed, a ‘borrowing base’ may be established whereby an ongoing collateral pool is established against which a maximum advance is computed
- Credit analytics is applied to the borrower in the normal way to ensure on-going viability and cash generation ability especially by means of a firm take-out by means of sale to a reputable buyer, and to establish that dependence on realising security is minimised
- There is a risk of the borrower double-pledging the same inventory. This can only be mitigated by the financing provider’s due diligence and, where relevant, a good choice of warehouse provider with adequate controls
- All the above risks are also mitigated by a robust monitoring, reporting and audit process regarding transactions, systems and controls.
Transaction flow: illustrative only
Source: Global SCF Forum
Procedures are required for the disbursement and repayment of the financing; the perfection of the security interest through the assignment of rights; the possession and control over the inventory being financed; the continuous monitoring of the condition and value of the inventory; and the calculation of margin and borrowing base as applicable. If the value of the inventory has been hedged in the futures market this also requires continuous monitoring.
The main benefit of this form of SCF is the ability of the client to obtain funding based on the security of easily realisable assets and bridging the working capital gap between the point of procurement and the achievement of sales.
For the finance provider it provides a short term business opportunity based on an expected source of repayment and readily realisable security.
Such financings are typically offered by one finance provider although in the event of very large amounts distribution techniques might be used.
Pre-shipment Finance is the subject of a separately defined SCF technique. Inventory finance for goods in transit may be provided under classical trade finance mechanisms such as letters of credit or by another means of structuring the financing and taking a security interest.
A variation of inventory finance is based on ‘tolling’, whereby finance is provided to allow raw materials or components to be submitted to a third party refining or manufacturing process prior to onward sale.
A variation of inventory finance is based on a borrowing base, whereby a maximum level of finance is made available against a calculated market value of goods (which could be of more than one type) being financed less a margin which will vary according to the quantity or quality of the goods.
Although inventory finance is normally provided as a Loan or Advance against assets remaining on the client’s balance sheet and with recourse, in selected cases a ‘true-sale’ may occur and the inventory may be removed from the (original) inventory owner’s balance sheet. Under such an arrangement the finance provider enters into a ‘sale and repurchase’ (repo) agreement for the goods being financed. In less common cases involving a true-sale, there may not be a repo, but a more general obligation to retire the funding.
A further model for inventory finance may be offered by means of Floor Plan Finance whereby finished stock is placed in the hands of a distributor by a manufacturer and financed by a finance provider
Trading parties may enter into a variety of inventory finance transactions for the management of inventory or work in progress, whereby the latter may be physically on the premises of one party but under the ownership of and financed by the other party. Such models are referred to as Vendor Managed Inventory (VMI) or more traditionally consignment stock.