Asset Based Lending Inventory Haircuts on Work in Process Scrap Inclusions
Asset based lenders apply steep haircuts to work in process inventory containing unseparated scrap to prevent standard cost card yield errors from inflating borrowing bases.
Work in Process Haircut
Meaning
A conservative discount applied to the recorded value of partially completed goods represents the risk and cost required to finish production. Applying a work in process haircut during financial audits or inventory evaluations ensures that lenders do not over-leverage based on incomplete inventory that cannot be sold immediately. This discount provides a realistic liquidation value of current assets.
Discount Application
Lenders or auditors assess the stage of completion of the inventory and apply a standard discount, often running from thirty to fifty percent, to the recorded value. This reduction accounts for the potential difficulty of finding another manufacturer to complete the goods if the current operator fails, as well as the cost of transport. Furthermore, the assessment acknowledges that scrap value represents the only viable alternative in a liquidation scenario.
Asset Valuation
Reducing the asset value on the balance sheet affects the borrowing base for asset-based loans, reducing the available credit line. This mechanism forces manufacturers to maintain higher liquidity or accelerate production to turn work in process into finished, un-discounted goods. This pressure encourages operational efficiency.
Review Procedure
Auditors review the haircut percentages during annual audits, adjusting the rates if the company’s production cycles or supply chains experience delays. Longer production times increase the risk of obsolescence and require higher haircuts. Regular reviews keep the borrowing base aligned with real risks.