How Do Your Borrowers’ Inventory Practices Stack Up?

Although borrowers often pledge inventory as loan collateral, the amount shown on their balance sheets isn’t always accurate. In fact, inventory can be a source of mistakes because its accounting is complex and the volume of transactions that flow through the inventory ledger is high. If management is lax about inventory, problems can easily spiral out of control.

Pandora’s box

Consider a borrower’s aged inventory. It may include obsolete or damaged goods that should be auctioned, donated, destroyed or otherwise removed from the books. Alternatively, some owners treat inventory as a “slush fund” for out-of-balance accounts; when the books don’t reconcile, they simply “plug” the difference to inventory (or cost of sales), rather than dig for the source of the discrepancy.

Even worse, a desperate borrower might bury fictitious year end journal entries in the inventory account as a way to mask poor performance. This strategy artificially inflates inventory and profits, enabling under-performers to temporarily stave off unwary lenders and buy time to turn things around.

Lean and mean

Strong inventory management is a defining characteristic of top retailers, manufacturers, distributors and contractors. Lean inventories free up cash for other business opportunities, such as launching a new product line or purchasing equipment. Plus, the lower a company’s inventory, the lower its carrying costs, including storage, security, insurance and loan interest expenses.

The trick is finding the balance between minimizing inventory costs and maintaining customer service. Often, CFOs are at odds with salespeople and plant managers over inventory levels. Inventory management software programs can help borrowers balance these conflicting objectives by tracking inventory trends, forecasting demand and identifying reorder points.

Careful counting

A borrower’s inventory management program is only as reliable as its underlying data, however. Although required annually by generally accepted accounting principles (GAAP), physical inventory counts are more than a compliance issue. They verify that the amounts shown in the accounting system match the number of units on-hand.

Companies should begin preparing before the physical inventory date by assigning and training personnel, cleaning up the warehouse, labeling inventory, and pre-counting slow-moving items. It also helps to minimize inventory on hand by, for example, completing customer shipments, postponing supplier shipments and discounting or disposing of overstocks and obsolete items.

Strong borrowers also implement controls over their inventory. Companies should limit access to inventory and monitor those responsible for reordering. Security measures such as locks, cameras and alarms are essential. Owners should periodically review their inventory ledgers for unusual transactions, such as those with round numbers or ambiguous journal entry descriptions — especially if they appear at the end of the accounting period or are later reversed.

Warning signs

One of the most significant signs that inventory might be incorrect is unusual financial statement trends. For example, lenders might notice that inventory has grown as a percentage of total assets, or gross margins have changed significantly. Such trends may forewarn of problems such as overstocks, write-offs, errors or fraud.

Also tour your borrowers’ facilities, letting common sense guide you in answering these questions:

  • Are shelves organized and units clearly labeled?
  • Can workers find inventory items quickly?
  • Are items logically organized (for example, similar items grouped together, heavy items located on low shelves and fast-moving items located near receiving/shipping)?
  • Does the company use a computerized inventory system?
  • Are any inventory items dusty or expired (if perishable)?

Trust your instincts during site visits. Lenders offer fresh outside perspectives and may point out inefficiencies that company personnel have overlooked for years.

Outside assistance

Inventory accounting is outside the comfort zones of most lenders. But independent financial experts can help when financial statements or plant tours raise red flags about inventory management.

CPAs can help borrowers select and implement inventory management software, review overhead allocation rates, coordinate and audit physical inventory counts, conduct price testing, evaluate or modify internal controls, identify write-offs, and investigate for fraud. Peace of mind is just a phone call away.

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