How much information your lender wants to see from you is dictated by their assessment of your risk profile. How much availability do you need? Will you actually utilize your line or are you just using it as a safety net? What are the market conditions of your industry? How leveraged are you? What risk factors affect your business?
- Market Concentration Risk?
- Customer Concentration Risk?
- Vendor Concentration Risk?
- Inventory Risk?
- Does the company have slow moving or obsolete inventory?
- Is the inventory over-valued?
A company needs to be able to paint a picture of how these risk factors are mitigated and have that picture ready for showing at any given time. Also, your painting needs to be contemporary. No one wants to see a Renaissance piece that doesn’t accurately reflect the current status of the company and the direction the company is heading. This is achieved by having this information as part of your routine financial reporting and planning process.
Commercial Lending is where most companies start out their capital acquisition process. The primary advantage of Commercial Lending is the reporting, auditing and valuation requirements are less onerous. Also, Commercial Lending has less direct and indirect costs. At the heart, commercial lending has the same basic requirements as asset based lending: a set of financial statements, a borrowing base calculation and a compliance certificate.
The borrowing base is a calculation that shows the value of your pledged collateral at a point in time. In a typical commercial lending situation, reporting is required monthly and is typically based upon a percentage of eligible accounts receivable and inventory, which is usually valued in the same manner as it is on the company’s books. Eligible accounts receivables and inventory are found by deducting any pre-defined “Ineligibles”. Ineligibles take into account items that are perceived to have more risk, such as aged inventory, aged accounts receivable, and accounts receivables with a concentration of aged invoices, customer concentration risk and foreign risk. In a commercial lending environment these ineligible items may not be as clearly defined as in an asset lending environment. For instance there may not be a definition of what constitutes “slow-moving and obsolete” Inventory leaving the interpretation of what constitutes “slow-moving and obsolete” to the company.
In general, the lending industry sets the bar for ineligible inventory at inventory that has not been used for one year, depending upon the type of business and business cycles. Accounts receivable are usually considered ineligible at 60-90 days. Terms can be different for customers that have a lower risk profile and are able to be negotiated up front.
There may be even more room for flexibility in terms utilizing an asset based lending platform as these borrowing base reports tend to be more customized to the client’s needs. Even though flexibility is a selling point, the primary advantage of the asset based lending model is the potential for increased availability. Asset based lenders usually will consider larger deals than commercial based lenders before having to partner with another organization in a “Club Deal.” In exchange for this flexibility, the fees and interest rates are usually higher and there is increased scrutiny and reporting requirements.
For instance, the commercial lender may agree to accept an internally generated balance sheet and income statement or a lesser level of accounting report such as a compilation or review (again dependent upon risk assessment). Alternatively, asset-based lenders are more likely to require an audit report. Asset based lenders tend to prefer reporting on a more frequent basis, such as weekly. The borrowing base reports are significantly more detailed and are more likely to be subject to field audits by the lender, the cost of which will be borne by the client. Lenders may even require audits on a more frequent basis than annually if the risk assessment warrants. Independent valuations of inventory and other collateral such as real estate that may secure the line are more common in the asset based model. These valuations can lead to a higher discounting of values from the amount reported on the books and records of the company. For instance, although asset based lending may provide a higher advance rate on inventory, the starting point for valuation may be net orderly liquidation value rather than lower of cost or market. That is the cost at which the inventory would be sold if the lender had to seize and liquidate the inventory, less the cost associated with the liquidation process.
Regardless of which financing vehicle works best for your business needs, you still need to paint the same picture of why you need the financing and what you are doing to mitigate the inherent risk in your industry and environment. This picture should consist of solid, accurate and timely financial statements. Although, the lender may accept a balance sheet and an income statement they will likely prefer a full set of financials including a statement of cash flows and notes to the financial statements. A well formatted, full set of financials illustrates a different level of sophistication to your lender than one that is simply printed from the accounting software.
Financial Statements provide the background of your picture and may be enough for your current needs. However, it is a good idea to have a more detailed financial package available, if requested by the lender. Some reasons for having more information than required readily available include but are not limited to:
- A business opportunity that arises that needs immediate capital outlays
- An unplanned market down-turn, such as what is currently being experienced in the oil and gas industry
- An unplanned natural disaster such as hurricane or flooding
When contemplating an increase in credit facility, lenders like to see a solid business plan that includes the following information: forecasts, budgets, 13-week cash-flow projections and long-term cash flow forecasts. These financial reports are also excellent tools for making operational decisions.
For cash flow statements, they have key information that show a company’s ability to cover their obligations, a few of these are listed below:
- Can the company pay its cost of human capital (employee’s salaries and benefits)?
- Can they cover their facilities cost?
- Can they pay their tax obligations?
Another point to keep in mind is that a lender can give you a credit line, but if the company does not have the borrowing base to support it, it will never be able to utilize the full capacity of the line. It is important to include a forecast of your borrowing base availability with your cash flow forecasts, this is especially important during periods of tight liquidity. Lenders typically like to see a good cushion of undrawn availability, usually between 15 – 20% of the total credit facility. Although, it is ok to temporarily max out your credit facility, lenders are adverse to clients constantly remaining at the maximum amount drawn. Staying in this position will increase your risk rating with the lender and therefore increase your costs, decrease your ability to increase the credit facility, and increase audit and documentation requirements.
Lenders, also, like to see how the company is performing compared to its budget by analyzing plan to actual variance data. So it is best to have this information readily available to the lender, if it is requested.
If these items are prepared as part of routine reporting and planning process, then you will be ready if the need arises. Additionally, you will have a vivid picture that tells the story of where your company has been and where it is going. Further, you will have invaluable tools to help you in making your operational decisions. It is a win-win situation with both practical everyday application and an insurance policy and disaster recovery document all in one.
For more information, please contact a member of the Whitley Penn Tax Team.
Tax Senior Manager