Asset Based Lending
- 1. Bob Grant’s…. April 2011 T IMELY T OPICS Rgrant56@gmail.com 248-321-1405 Avoiding Pitfalls in Asset Based Lending (Asset Based Lending-Lite) As banks look to diversify from concentrated levels of will be collected. CRE lending, a renewed interest in traditional Commercial and Industrial lending has developed. Pre-billings: arise when a borrower issues My formative years were in C & I lending, so I thought accounts receivable invoices before they have I would provide a quick refresher on a few of the key shipped products or services. Often times this elements of asset based lending. Not pure asset occurs at a quarter or year-end in an effort to based lending, where the highly leveraged balance accelerate revenue, but it can also be done simply sheet is viewed acceptably, and where specific invoice in an effort to accelerate cash flow by a borrower financing occurs, but for more moderate risk profiles. with thin working capital. Regardless, pre-bills should be excluded from any borrowing base. A borrowing base (advance formula) typically governs Pre-bills often go undetected unless there is a a line of credit where line advances are made against field audit. a percentage of eligible accounts receivable, and sometimes against a typically lower percentage of Other: contractor receivables are an obvious one, inventory. The quality and proof of accounts due to the Michigan Builders Trust Fund Act. receivable is critical and should be validated by a pre- Agency receivables are another type to watch out funding audit (and preferably some regularly for (insurance agents, the media portion of scheduled audit thereafter). These field audits are advertising company receivables, etc.). Highly often performed by third party professionals with the concentrated, foreign sourced and certain costs being absorbed by the borrower. A government receivables may be ineligible. rudimentary view of what to look out for includes: Work in Process Inventory: Should be excluded Accounts Receivable Dilution: essentially any portion from your borrowing base. This is often a real of accounts receivable identified as going issue with companies that have longer cycles like uncollected. Discounts, returns, chargebacks, trade machine builders, transfer lines and other allowances, bad debt, etc. all dilute the quality of the “project” related inventory. accounts receivable and need to be excluded from the eligible receivables. Common issues that are identified through field audits include: Dilution and its calculation, Progress Billings: the goods or services being flexible accounts receivable terms not properly provided are not complete, but partial billings are disclosed, the over estimation of inventory allowed. Obviously, should the bank be in a position values, poor inventory controls, and inadequate where it needs to collect the receivables, collection on inventory testing. unfinished goods or services is highly unlikely, at best. While the customer may truly need the good or Other fundamental issues that should be service, the fact that there have been progress considered are balance sheet leverage, the level payments make it unlikely that any further amounts of trade payables and other accrued expenses.
- 2. Page 2 Timely Topics A few other thoughts on lending against inventory. Of course, you do need to build a monitoring Do so selectively. Is there good gross margin in the system to assure proper line advance controls are product? If it is a very low margin product, arguably in place. Typically, banks require a borrowing the risk of lending into inventory increases. One base certificate, accounts receivable and accounts way of dealing with that is to maintain a lower payable agings on a monthly basis, though bi- advance rate. Generally, we are dealing with fewer weekly or weekly may be required for some Audited Financial Statements which increases the accounts. Obviously, the monitoring system risk of the value of inventory presented in the should have independence from the relationship financial statement. You can require a “special manager and should provide alerts to appropriate procedure” where you have the accounting firm management if there is an “out of formula” specifically do inventory testing of some level. Still, occurrence or the account hits predetermined a qualified field audit should be done at least at the triggers. time of original funding to build a baseline of the real inventory risk. There are several very competent field auditors based in Southeast Michigan. Of course a number Be aware of lending against specialized products of accounting firms will do field audits, though that are saleable to only a limited number of buyers. their levels experience varies quite a bit. I have Also, don’t underestimate the obsolescence used Lender Solutions, Inc. a number of times and risk…there is almost always some inventory that is find them responsive, flexible and knowledgeable. not of real value. Finally, if inventory is housed at Contact Theresa Zitkus at 248-442-9600 several locations, be alert to the increased risks and (www.lendersolution.net). I also know that Plante the even greater import of good inventory controls. & Moran does some field audit work and I have used them for ‘special procedures’ on several I know you won’t forget that personal guaranty. occasions. While the guarantor may or may not have the wherewithal to pay on the loan, the guaranty may be important in helping you collect accounts receivable or convert select inventory in to saleable inventory if things go awry.