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Accounts-receivable secured lending: looking over your shoulder
RMA Journal, The, July-August, 2004 by Mark Zoeller
This article concentrates on the accounts-receivable secured portion of asset-based lending. It's not so much a comprehensive "how to" as "ways to improve," which tries to bridge the gap between what our author has observed and the industry's best practices.
The senior loan officer told me, "We don't get interim financial statements and don't get collateral audits because the bank doesn't have the resources to do asset-based/ending right." I was speechless.
Accounts-receivable secured lending is the bread and butter of asset-based lending, which can also include inventory lines and equipment finance lines. It is not, however, riskless. When done right, A/R secured lending is about risk assessment, risk management, and return on the risk. A bank can take steps to reduce losses, and a bank may be able to price for losses, but a bank cannot eliminate losses.
Policy
A/R lending policy should be a somewhat flexible statement of the bank's current portfolio blueprint, its strategy, its risk appetite, its return/risk requirements, and its culture. The bank's policy may be a mere sentence or two about lending against accounts receivable or something far more extensive. Brief or extensive, however, the policy often is ignored, and making policy useful requires the bank to track and limit policy exceptions.
Some banks not only fail to track exceptions, they do not even recognize exceptions. Management tends to feel that any time the board of directors approves a loan there is no policy exception because the board has created a new policy. This makes any policy meaningless, and the bank is not managing the risk.
Borrower selection, pricing, line structure, and managing the credit should be risk based. The legal documentation and legal follow-up are part of structure and managing the credit.
Borrower Selection
Good collateral cannot make up for the wrong borrower. What risks does the borrower represent? Loan officers and credit officers sometimes seem oblivious to the following basic truths:
* Nothing can substitute for cash or the borrower's ability to generate cash. Cash flow tends to take a back seat to the reported amount of A/R. It is cash flow, however, that allows the borrower to grow and thrive.
* An A/R line should not be permanent capital. Eventually, the borrower should be able to convert the line into two parts: a short-term line that is regularly paid down to zero and a term loan. A term loan, though, requires free cash flow or UCA cash flow to repay it. I have not recently seen any loan approval that uses cash flow as a measure of the borrower's ability to repay a potential term-out on part of the line.
* Subordinated debt is not a riskless substitute for equity. The most common practice is to add subordinated debt to equity and pretend that they are the same.
* Super-rapid growth can lead to big problems. It is hard for a borrower to transition smoothly from rapid growth to no growth or even into decline. I seldom see loan approvals address the rapidity of growth as a risk element.
* Footnotes to audited financial statements often contain important information. For example, loan officers frequently overlook the potential effect of large debt maturities in, say, two years.
Pricing
A/R lending prices should include the probability of default, estimated loss upon default, and the cost of managing the risk. The higher the risk, the higher the price. Many community banks, however, price at whatever the local market will bear. If the bank is trying to gain market share, the price might be below what the local market would bear. In community banks, A/R line prices also tend to be not much above the prices of seasonal lines of credit. Thus, higher-risk A/R borrowers may pay little more than what lower-risk seasonal borrowers pay. This rewards the high-risk borrowers and penalizes the low-risk borrowers. How can the bank maximize its return/risk ratio if all risks are priced the same?
Advance Rates, Eligibility, and Structure
Policy maximum advance rates have drifted toward de facto standards. Some banks' A/R lines all have an 80% advance rate. Other banks use 80% (and some, 85%) as a working minimum, with some lines exceeding 80% without the loan officer(s) stating why it was appropriate.
The 80% is but a starting point. The advance rate should consider:
* Dilution rates.
* Small invoice size.
* Lower quality and nature of A/R debtors.
* Concentrations.
Dilution measures how much of each sales dollar comes back or is not collected. Examples include credit memos for returned goods, mispricings, or invoice errors; advertising allowances; trade discounts; contra account credits; and credit losses. The real question, then, is this: For each dollar of sales, how much sticks? In other words, how much of each sales dollar will be collected? Collateral auditors usually calculate the dilution rate monthly for the preceding 12 months and then calculate the 12-month average. On occasion, auditors will indicate recent changes in the dilution rate.
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