This article appeared in the Vibrant Publishers Financial Management Essentials You Always Wanted to Know. I will be a contributor to Vibrant in the future. Please consider their textbook line. Their catalog and products can be found at http://www.vibrantpublishers.com
Banks make lending decisions based on the 5Cs of credit:
- Character: How reputable is the borrower? Does he or she have a history of satisfactory transactions with other banks?
- Capacity: Will the borrower have sufficient cash flow to repay the loan?
- Collateral: Should the borrower not be able to pay the loan are there available assets the bank can liquidate to pay the loan?
- Capital: How much do the owners have invested in the company? This provides a shield against potential losses for the bank.
- Conditions: What will the funds be used for? What industry is the borrower operating in? How is the strength of the industry and the general economy?
While a bank will consider all of these factors, it never really wants to foreclose on business collateral. This can take a lot of time and money. Banks will also require the borrower have sufficient capacity to repay the loan. Consequently, a bank will not make a loan to a property rich company that has insufficient cash flow to make the required interest and principal payments. Banks will also not make a loan to a company with little or no equity. In situations like this, the bank would be making a much riskier loan than it would ordinarily want to make.
There are various types of bank loans. Two common types are asset based secured revolving lines of credit and term loans. Let’s look at how each of these work.
A secured revolving line of credit (also known as a “revolver”) provides a working capital loan equal to an amount based on the borrower’s assets and calculated by an agreed upon formula. For instance, a loan agreement can provide for available funds up to 80% of accounts receivable, 50% of inventory, and 50% of current equipment value. The borrower fills out a borrowing base certificate documenting the amount of funding it has available from the bank. This is done on a monthly, weekly, or even daily basis depending on how closely the bank wishes to follow the company. A bank feels comfortable extending credit to the borrower because the formula provides sufficient liquid collateral to protect the bank against credit loss. The bank will further protect itself by requiring the borrower to subtract out certain assets from the computation. For instance, accounts receivable 60 days or more past due and government receivables are commonly subtracted from potential collateral before the borrowing base is calculated. Other common subtractions are work in process or obsolete inventory, since neither can be liquidated quickly.
Example:
ABC Company has provided the bank with the following information:
Accounts receivable: $1,000,000
Accounts receivable past due 60 days 100,000
Inventory 2,000,000
Eligible equipment 100,000
Total potential collateral $3,200,000
What is ABC’s borrowing base?
Solution:
Net eligible accounts receivable $900,000
Lending percentage 80%
Available loan against accounts receivables $720,000 (a)
Inventory $2,000,000
Equipment 100,000
Available as collateral $2,100,000
Lending percentage on inventory and equipment 50%
Available loan against inventory and equipment $1,100,000 (b)
Total loan available (a) + (b) $1,820,000
Therefore, this company can borrow up to $1,820,000 by using its accounts receivable, inventory and equipment or approximately 56% of the total potential collateral value.
Banks may also issue term loans. Term loans have a fixed repayment schedule and may have floating or fixed rate interest payments. One critical piece of information bankers look at before making a lending decision is EBITDA—earnings before interest, taxes, depreciation and amortization. We have previously discussed EBIT. EBITDA is simply EBIT plus any depreciation or amortization recorded in the period. These two expenses do not require the use of cash so they are added back to EBIT when estimating the amount of cash flow a company has available to repay its loans. The total amount a bank will lend is often governed by the debt to EBITDA ratio (also known as a multiple). Let’s take the following example:
Suppose a bank is willing to lend a company up to two times its EBITDA. The potential borrower has EBITDA of $1,000,000, but also already incurred interest bearing debt of $500,000. The bank will be willing to lend an additional $1.5 million to this company.
EBITDA has another useful function. Investment bankers use EBITDA to estimate the value of a company. This topic is beyond the scope of our discussion here.
Banks using EBITDA to measure borrowing capacity will also limit the amount of capital expenditures (“capex”) a company can make in a year. Capital expenditures reduce the amount of cash flow available to make required loan payments. Since capex is not included in the calculation of EBITDA, a separate limitation is often imposed on these purchases.
Banks will often require personal guarantees to further protect its position. Business owners often organize their companies to prevent personal liability (e.g. as a corporation or limited liability company). However, financial institutions can collect the loan from the owner when the business defaults on the loan payments if a guarantee in place. Banks can also ask for side collateral. Side collateral consists of assets pledged to secure a loan, but whose value is not as great as the loan amount. It is only a partial collateralization of the loan. Side collateral is often used to further collateralize a loan. For instance, in our example above, the bank could also ask the owner of the company or the company itself to pledge $500,000 in marketable securities as additional collateral against the loan.
Finally, the bank will often impose covenants on the borrower in the loan agreement. A covenant is a legally binding promise the borrower has made to the lender. Typical covenants include capex limitations, times interest earned requirements, debt to EBITDA requirements and providing the bank with current financial information. These are some of the more usual bank covenants, but this is in no way an exclusive list. Covenants are often tailored to the particular borrower’s conditions. Management must pay close attention to covenant compliance because violating the covenant, no matter how insignificant it seems, may result in a breach of the lending agreement. In such situations the bank may call (require immediate payment) the loan. While there is very little chance of this happening if the borrower has been consistently making payments, accountants take a very draconian view of this situation. If the loan agreement allows the bank to call the loan as of the balance sheet date, the loan must be classified as a current liability. The required financial statement disclosure can be very embarrassing to a borrower, particularly if its customers want to see its financial statements to make sure the company is financially sound. The classification of the loan as a current liability will negatively impact the current and quick ratios of the company, as the increased liability decreases net working capital. Even if a waiver of the violated covenant is obtained after the balance sheet date but before the issuance of the financial statements, the loan will still be classified as a current liability. Obtaining a waiver from the bank will also be expensive. The bank will often charge a substantial fee for waiving the covenant.
The best time to apply for a loan is when the company is doing well. The company will have EBITDA and collateral in the form of accounts receivable and inventory to support the loan. Many companies make the mistake of waiting until there is an immediate need for working capital or even worse, when the business is experiencing a downturn. Bankers may not be interested in extending credit when the potential borrower is experiencing operational stress.
Mark Koscinski CPA D.Litt. 