The borrowing base impacts cash flow and equity
A discussion of the borrowing base is included here
mostly for its educational value. The goal is help investors visualize the
mechanics of cash management. A company’s credit facility usually contains a
portion of asset base lending, usually in the form of a revolving line of
credit, which is collateralized by the company’s accounts receivable or
inventory. The borrowing base is the documentation needed for bank advances
to fund a company’s check book. The credit line normally contains
conditions, which protect the lenders and limits the company’s borrowing
capacity, such as:
The Advance Rate – The rate that is advanced to the
client on his eligible collateral. Normally, accounts receivable may have a
70% to 80% advance rate. Notes and lease receivables are typically
discounted to their present values, and may have an 85% advance rate. That
can translate into almost 100% of cost or cash outflow.
Inventory usually has a
much lower advance rate, usually in the 50% to 60% range.
Ineligible Collateral – The portion of the collateral
that the lenders will not loan against, such as: past due receivables over
90 days old, WIP inventories, or inventories located in certain foreign
countries. For example, inventory located in Mexico is normally considered
ineligible by U.S. lenders, while inventory located in Canada is usually
depends on the lenders’ ability to obtain a preferential/perfected interest
in the collateral, and their right to repossess the asset if the company
defaults on its agreement. Every lending agreement is different, and the
loan conditions depend on the specialty of the lender.
If collateral becomes
ineligible (i.e. receivables over 90 days past due) new collateral must be
substituted or the loan repaid. In situations where collateral turns
ineligible and cannot be replaced, or the loan repaid, the company would be
in breach of its loan covenants.
Funding Restrictions and Supplier Contributed
Every agreement is negotiated differently. Some
lenders have no restrictions on collateral that is paid in accordance with
the supplier payment terms, which normally are 30 to 60 days after receipt
of the merchandise. Other lenders only allow collateral to be eligible after
the suppliers have been paid.
If there are no supplier payment conditions in the
revolving loan agreement, in effect the suppliers are providing equity
financing to your company.
For example: a company spends $1,000 to purchase
inventory that is paid for up-front. Assuming a 50% advance rate, the banks
would fund $500 and the company's equity would pay for the second $500.
If that same inventory item is sold on credit for
$1,250 and the company now has a 75% advance rate, the banks are funding
$937.50 and the remaining $62.50 is coming from the company’s equity.
Now, assume the suppliers give the customary 30 to 60
day payment terms and the banks have no payment conditions on the eligible
On the $1,250 receivable, the company is able to
borrow from the banks the same $937.50, but with no cash outflow to the
suppliers. In effect, the company has “supplier contributed equity.”
The critical cash flow concerns for investors deal
with the impact that the borrowing base has on the Company’s liquidity and
leverage situation. The unused availability on the borrowing base is
the amount of funds a company can draw down immediately. The unused
portion of a credit line may need eligible collateral before it can be
drawn upon. It’s a subtle but significant difference.
A company’s revolving asset-based loans have
characteristics similar to stock margin loans. Investors, when reviewing
liquidity issues, should look for a company’s available but unused line of