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Evaluate Inventories Like an Asset Based Lender

November 16, 2012 | About:
Inventories are the lifeblood of firms, as they represent what customers pay for. They rank third in the line, in terms of short-term liquidity, after cash and accounts receivable. Like cash and accounts receivable, inventories typically contribute a large part of the net current asset valuation used in determining if a stock is a net-net case. In addition, inventories are used in the calculation of the current ratio and the cash conversion cycle, key indicators of short-term liquidity.

Unlike banks, which typically lend to companies on the strength of their cash flow, asset-based lenders often look for asset-rich companies with negative cash flow. Inventories, accounts receivables and real estate are assets that asset-based lenders focus on.

An asset-based lender will evaluate the quality of inventories in a step-by-step manner.

First, the breakdown of inventory can provide insights to the value investor. Inventories can be broken down into raw materials, work-in-progress and finished goods. A large raw material inventory may indicate stockpiling of raw material, while a significant order backlog may be reflected in a significant proportion of inventories stuck at the work-in-progress level.

Second, the marketability of various types of inventory differs. While most inventories can be sold at or close to book value, consumer electronics such as smartphones and high-end apparel can quickly be obsolete and sell for significantly less than cost.

Last, certain types of inventories may suffer from lack of market depth. Specialized equipment such semiconductor testing equipment and fresh produce may not find sufficient buyers for a realization of value within a specific period of time.In calculating the net current asset value and the current ratio for a company, investors should write-down the value of inventories based on their characteristics.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap deep-value cigar-butts and wide-moat compounders. He publishes value investing case studies, investment checklists, and potential stock ideas on the Cheapskate Investing blog. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website

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