In this article we discuss the ways in which critical discovery efforts, undertaken by experienced professionals, can provide the insights and assurances both lenders and borrowers need to address working capital issues in the current volatile market.
Working Capital challenges in the current economic climate are encouraging corporations and financiers to explore extended funding solutions using companies’ Accounts Receivable (AR), Inventory and Plant & Equipment (P&E) as collateral. The economic environment is also changing rapidly, generating both positive and negative outcomes for businesses, which in turn, is testing corporate debt covenants, raising risk, and ultimately creating uncertainty within lender’s credit departments.
Financing availability is also beginning to be challenged and constrained as lenders focus more closely on the credit profile and ensuring covenant compliance by borrowers. In this environment, Hilco as a provider of indepth diligence and valuations across asset classes is helping lenders and their credit departments navigate many complex issues.
Recent assignments undertaken by Hilco have highlighted these working capital issues to us and for our clients. Of particular relevance, are assignments undertaken in the building materials industry and the construction industry it serves. To illustrate these issues in detail, we will review 2 unique cases, first touching on availability within AR and Inventory assets, metrics often determined through our work on behalf of clients.
When lending against working capital it is critical to determine the true availability from AR and Inventory asset classes. For AR, true availability takes into account not only dilution and aged receivables but further considers cross aging, contra tests, concentration limits, rebates, foreign customers, overaged credits, and intercompany as an example. It serves to identify, verify and test the collectability of the outstanding revenue of the business and establish a more accurate truer security amount from the asset class that lenders can then use to mitigate risk.
In the case of Inventory, Net Orderly Liquidation Value (NOLV) needs to be calculated if following industry norms whereby a liquidation event is considered to provide the base measure for the loan amount. This is vastly different from reported Inventory on the balance sheet which represents the lower of cost or net realisable value across raw material, work in progress and finished goods. The NOLV calculation in contrast takes careful consideration of Inventory items and their ability to be realised within a typical 10–12-week timeframe. This analysis digs into the turnover and margin of individual stock keeping units (SKU’s) as well as sale channel options in the challenging liquidation environment. In this analysis right of access, costs of sale, slow moving stock issues, and WIP to FG conversion economics all need to be considered in determining a true availability from Inventory.
P&E is not typically considered working capital but can be and is often used as ‘boot’ collateral to further secure a loan. This is especially the case in capital intensive industries. The building materials industry is moderately capitalintensive dependent on business operating models within the sector. In some cases where manufacturing and logistics assets are owned, they can provide significant additional comfort to a lender.
The use of a third party, such as Hilco, to assess availability from a complex basket of Balance Sheet assets is clearly highly supportive of new and ongoing relationships between lenders and borrowers. At Hilco, we find ourselves performing this role with increasing frequency.
Australian corporations within the building material supply industry are currently experiencing changing business fundamentals for working capital including high-revenue growth, supply chain issues, and increasingly aged AR. This is a direct result of Covid economic effects both during and in the post stages of the pandemic which we are all now experiencing.
For our first case example, during and after Covid, growth for the business accelerated due to a strong rebound in building activity. The rebound being a result of demand and government stimulus. To counter issues with supply and the need for greater inventory to support growth, our client was encouraged to increase inventory orders and forward order inventory. This decision was taken by agreement from their current lender and funded through increased debt levels against AR. In our example the business decision led to a critical overstocking event as supply constraints unwound, pushing inventory levels to a maximum within the business. Should sales forecasts be met, and a normalising of the supply chain occur, then this will likely be a short-term issue.
However, due to the increased inventory holding days, inventory turnover slowed and there was an increase in the value of slow-moving stock. These key business metric declines presented less availability, countering the loan extension rational and presented the lender with a significant issue to manage. Margin, another key input to availability, was also eroded slightly adding further concern.
To support confidence in managing this finding, Hilco undertook a deep analysis on the business. This step enabled us to pinpoint specific areas of concern, address these with both parties and provide monitoring points to the lender for tracking performance over the length of the issue. It further provided confidence in the initial rational and growing beneficial relationship between lender and borrower.
It is important to note, margin pressure within the business due to inflation was not considered a major issue because of the ease in passing along price inflation from this commodities-based product. However, if competition and slowmoving Inventory issues became the driver, then the effect on true availability could be dramatic. Competition at the time was in the company’s favour after major players closed or made poor decision through Covid.
Our second case example is related to increased AR aging within the building materials industry due to delayed payments from the builders they serve. Increased AR aging affects availability and business risk in many ways and is most evident when considering availability to AR ratios as a key availability reporting metric for growing businesses.
The building industry, and in particular major builders, are navigating many significant issues in the current economic environment including material supply constraints, stage completion delays and inflation. Inflation is a critical issue for major builders on fixed building contracts, as these do not allow for material cost to be passed along to customers. This working capital crunch for builders has pushed a few into insolvency already, and for the material suppliers this is putting pressure not just on Aged Receivables but also on credit limits, dilution, and concentrations to name a few.
In this environment an invoice financing client of Hilco’s received a request to extended availability to its building materials supply client. The building supply company was, again, a growth story and in need of further working capital for increased inventory and business support. The challenge was that AR availability, the only secured capital, was being stretched by end customer issues and presenting considerable risks. To support the company’s objectives, inventory and P&E were identified as obvious solutions to provide further security to the lender for this loan extension. A thorough analysis of Inventory under a liquidation scenario to calculate availability provides a suitable risk benchmark. In this example P&E provided a small but important increase to overall availability.
Hilco’s diligence and valuation services support both lenders and corporates to help form and strengthen the relationships in a challenging working capital and funding environment by providing an in depth understanding of the assets represented in the Balance Sheet and the underlying availability they support. If your business or a borrower in your portfolio is being challenged by factors like those discussed in this article, we encourage you to reach out to our team for a conversation. We are here to help.
BEN RODEN IS MANAGING DIRECTOR AT HILCO VALUATION & DILIGENCE SERVICES.
His career has spanned over 20 years in valuing balance sheet assets across a range of industries. Over this time, Ben has acquired deep knowledge in Valuations, Monetization, Projects, Marketing, Business and Risk Management. Leading the Hilco Valuations & Diligence division of the Hilco Global APAC business, Ben brings an in-depth understanding of marketbased outcomes and access to global markets for businesses. Contact Ben at at +61 412 229 350 or firstname.lastname@example.org