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Understanding Financial Statements Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions

Cash Flow Analysis

 - The effects of growth on
    cash flow and earnings

 - How free cash flow
    benefits investors

 - Don’t blame EBITDA for
    your losses

 - The borrowing base
     impacts cash flow and equity
 - The debt repayment
    schedule can predict a
    liquidity crisis



 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 eligible.

Disallowed collateral 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 Equity

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 collateral.

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 credit.







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