Calculating the Inventory Cap for Asset Based Lines of Credit

Inventory Caps are used in structuring asset based lines of credit.  The Inventory Cap limits the amount of collateral the borrower can use for their borrowing base.  Let’s say a Lender is advancing to ABC Company at 80% of eligible Accounts Receivable and 50% of eligible inventory (generally standard terms for a credit-worthy Borrower).

There may be times when a Borrower has more Inventory than A/R collateral in the borrowing base.  In this case, the Lender may want to use an Inventory Cap to limit their credit risk.  If something goes wrong with ABC Company, the A/R collateral should be collected within 30 days and used to pay down the existing line balance.  There is more risk to the lender associated with the Inventory collateral, though, because it is not yet sold.

One way to calculate the Inventory Cap is to determine how many days of average cash receipts the Lender is comfortable with in addition to the 30 days it will take to collect Receivables.  For example, if average cash monthly cash receipts are $1 million, 20 days worth of cash receipts would be $667 thousand.  If the Lender is comfortable with this, the Cap could be set at $667 thousand.  Another method is to determine a dollar limit which is comfortable for the Lender to have an exposure in Inventory.