Advance against inventory

Feature | 25 August 2017
Inventory

TFR features the Global Supply Chain Finance Forum's standard definitions of loan or advance against inventory and pre-shipment finance

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, unsold, or hedged) and over which the finance provider usually takes a security interest or assignment of rights and exercises a measure of control.  

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 preshipment finance (see separate SCF technique definition). The finance of goods in transit such as onboard 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.

Parties

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.

Security

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.

Figure 1: Loan or advance against inventory

Source: Global SCF Forum

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 repossess 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 ongoing 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 illustration

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.  

Benefits

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.

Asset distribution

Such financings are typically offered by one finance provider although in the event of very large amounts distribution techniques might be used.

Variations

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.

Pre-shipment finance defined

Pre-shipment finance is a loan provided by a finance provider to a seller of goods and/or services for the sourcing, manufacture or conversion of raw materials or semi-finished goods into finished goods and/or services, which are then delivered to a buyer. A purchase order from an acceptable buyer, or a documentary or standby letter of credit or bank payment obligation issued on behalf of the buyer, in favour of the seller, is often a key ingredient in motivating the finance in addition to the ability of the seller to perform under the contract with the buyer.

Distinctive features

Pre-shipment financing covers the working-capital needs of the seller, including procurement of raw materials, labour, packing costs, and other pre-shipment expenses in order to allow the seller to fulfil delivery to its buyer(s). Pre-shipment finance can be provided in any number of structural variations. Financing can be provided against purchase orders (confirmed by buyer or unconfirmed), demand forecasts or underlying commercial contracts.

Although pre-shipment financing is most commonly provided in an open account situation, other sources of repayment from the buyer may also be the proceeds of a documentary credit or standby letter of credit or a bank payment obligation. Pre-shipment finance can be provided on a programmatic basis, covering a series of transactions (typically for smaller sellers) or on a transactional basis (typically for larger sellers).

The finance provider is likely to advance a certain percentage of the value of the order, potentially disbursed in stages as the order is fulfilled. Maturity dates for the financing are established between the seller and finance provider and are often tied to the ultimate date on which the buyer will make payment.  

Upon shipment, the finance provider may offer post-shipment financing using techniques such as receivables discounting, or payables finance to cover the period from shipment and the raising of the invoice until the final payment by the buyer.

Parties

A typical pre-shipment financing transaction involves two main parties: the seller and the finance provider. The buyer is not a party to the financing transaction but depending on the contractual arrangement with the finance provider, the source of the repayment is usually the flow of sales proceeds from the buyer. The history of the commercial relationship is a factor in determining the probability of repayment. Bank and non-bank finance providers are active in this type of financing, particularly in Asia.

Contractual relationships and documentation

The seller and finance provider enter into a financing agreement detailing terms of the financing structure. This may but will not always include a security agreement covering assignment of rights (transfer of title or a pledge) to the underlying work in progress and finished goods prior to shipment. The finance provider may require a security interest in the receivables following shipment. The seller may grant inspection rights to the finance provider or its nominated agent for the period of manufacture or conversion.

Security

As described in the previous section, a security agreement will be executed covering assignment of rights (transfer of title or a pledge) to the underlying work in progress and finished goods prior to shipment and to the receivables following shipment.

Risks and risk mitigation

The primary risk is the performance risk of the seller as repayment is dependent on the seller's performance ability and reputation. Specifically, the seller's ability to perform against the purchase contract, and the buyer's ability and willingness to pay on delivery of the goods are the key risks. Mitigation of risk is provided by the credentials of a creditworthy and reliable buyer and the proven performance of the seller in a repeatable and predictable fashion. Security over assets prior to shipment is an important control mechanism, but is not the primary source of risk mitigation.

Figure 2: Pre-shipment finance

Source: Global SCF Forum

Transaction illustration

The finance provider will work with the seller to establish a transaction structure, and will undertake credit assessment of both the seller and of the buyer in order to assess its credentials to meet its purchasing obligations. It will monitor the issuance of purchase orders by the buyer and provide finance to the seller in stages against materials purchases, work in progress and invoiced amounts. All subsequent actions and events taken by the seller once the order is received will be closely controlled and monitored in relation to fulfilment of the order. Sequential financing may occur in any chosen form as agreed by the parties.

Benefits

The benefit to the seller of this form of finance is the ability of the seller to obtain finance for the fulfilment of an order from a buyer, in circumstances where it is possible that other forms of finance are financially less attractive or not available. The benefit for the finance provider is that rather that there is greater control and reassurance based on the trading relationship between the seller and its buyer(s).

Variations

There are many variations on the technique of pre-shipment finance, such as finance undertaken against a general contractual framework established by a buyer with a seller, and finance extended against a letter of credit established by the buyer in favour of the seller (so-called red and green clause letters of credit).  

This is an extract from the 'Standard Definitions for Techniques of Supply Chain Finance'. TFR will feature extracts from the standard definitions on an ongoing basis to support consistency across the industry. The complete document can be found here: http://bit.ly/2nPlDXt

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