12 Jul Beyond the Balance Sheet: Why Relying Solely on the Balance Sheet for Inventory Values Falls Short

Inventory is typically one of the largest assets a bank uses for collateral. Having a proper understanding of the inventory count, value, and tracking process is an integral part of prudent lending and risk management.

Lenders, in particular, must recognize the limitations of relying exclusively on the balance sheet for inventory valuation. The balance sheet often fails to capture the true value of inventory for collateral purposes. The following factors contribute to the discrepancies between the reported balance sheet value and the fair market value.

Historical Cost Basis: The balance sheet typically records inventory at its historical cost, representing the original purchase price and direct costs incurred. However, this historical cost may not accurately reflect the current market value of inventory, especially considering changes in market conditions or items with fluctuating prices. Lenders need an accurate valuation that aligns with current market realities.

Market Fluctuations: Inventory values are subject to market forces such as supply and demand dynamics, consumer preferences, and industry-specific factors. The balance sheet does not account for these market fluctuations, which could be inflating or underestimating the inventory’s value. For example, if you purchased a product at a point in time when costs were down, and as of the Effective Date, the market has corrected itself, then your inventory on the balance sheet may be underestimated. A comprehensive understanding of inventory’s worth will help to make better informed lending decisions.

Obsolescence and Deterioration: Over time, inventory items can become obsolete, perishable, or deteriorate. The balance sheet overlooks these factors, potentially leading to an overvaluation of inventory that has lost demand or utility. A realistic assessment of inventory’s condition and market relevance is needed to help accurately assess risk and loan security.

Seasonal or Cyclical Variations: Many businesses experience seasonal or cyclical variations in inventory levels and demand. The balance sheet often provides an average value, a method used by many businesses to internally track inventory value. However, this fails to capture the inventory’s worth during peak or low-demand periods. A more precise valuation that considers these fluctuations will lead to more accurate risk assessment and loan evaluation.

Costing Methods: Different costing methods, such as FIFO, LIFO, or Weighted Average Cost, impact inventory valuation on the balance sheet. The most commonly used method to value inventory is the FIFO method, as it assumes the oldest inventory is sold first, resulting in a higher net income and a lower recorded cost per unit. However, the chosen method may not reflect the current market value or unique characteristics of the inventory. An independent appraisal will account for the specific costing method used and ensure an accurate valuation aligned with market conditions.

Inventory Management Processes: The efficiency and effectiveness of a company’s inventory management processes can significantly influence the value of inventory. Inadequate inventory management practices, such as inaccurate tracking, inadequate stock control, or inefficient replenishment methods, can lead to overstocking, stockouts, or excess inventory. These issues can distort the true value of inventory recorded on the balance sheet.

Lenders should consider how well a company manages its inventory as poor inventory management can lead to inaccurate valuation and potential financial risks. A thorough inventory appraisal takes into account the quality of inventory management processes ensuring that the valuation accurately reflects the inventory’s condition, turnover, and market demand.

To address these limitations, lenders must collaborate with qualified inventory appraisers to obtain an independent inventory appraisal. These appraisals consider factors such as market conditions, obsolescence risks, inventory management processes, sample counts, and current demand to provide a reliable valuation. By leveraging independent inventory appraisals, lenders can make better-informed decisions, accurately assess collateral value, and mitigate risks associated with inventory-based lending transactions.

Our team of ASA and CMEA appraisers have over a combined decade of experience appraising a wide range of inventory. Please reach out if you would like to discuss a project or if we can answer any specific questions.