freight factoring
account receivable factoring
invoice factoring

 

 

Collateral is another name for a borrower's bankable assets. It is what the lender can expect to draw upon in the event of the borrower's default. Naturally, collateral does not reflect dollar-for-dollar the value of the assets on the company's accounting records. Rather, various levels of discount, known as "advance rates," are applied.

Accounts receivable, for example, are applied a 70% to 85% advance rate in determining how much the bank will lend against them. Inventories have a rate of 30% to 65%, which usually excludes work in process unless tied to a particular customer order.

For equipment and real estate, the value is based upon an appraisal. Eenders will advance 70% to 80% of equipment's orderly liquidation value, and 50% to 80% of the appraised value of real estate. For equipment in use, 25% of original cost is a rule of thumb.

Together, assets valued at these advance rates comprise the pool of collateral upon which the bank lends. Conventional lenders expect their loans to be fully collateralized.

The second criterion is cash flow. Adequate cash flow must not only be expected in the future but also historically proven. Companies with cash flows that vary from positive to negative from month to month will have a difficult time obtaining conventional financing.

Lenders compare cash flow with debt service. Debt service includes the amount of interest expense plus the repayment of principal on term debt. Cash flow is operating profit before interest minus income taxes. The formula assumes that depreciation approximately equates to the need to purchase new equipment. If not, actual anticipated purchases may be substituted for deprecation.

The expected minimum ratio of cash flow to debt service ranges from 1:1 to 1.5:1, depending on the lender's perceived risk. This means that for every dollar of interest and principal repayment, the business must generate an equal or greater amount of cash after tax.

Finally, capital is an essential ingredient. Capital is the equity of the company, which includes amounts initially funded by stockholders plus cumulative earnings of the company from inception, minus dividends distributed. Debt that is explicitly subordinated to the bank's is included with equity or capital rather than debt.

Lenders compare capital with a company's total indebtedness. The relationship is expressed as the ratio of debt to equity. Total debt divided by equity or capital must be in the maximum range of between 2:1 and 4:1. At a 2:1 debt to equity ratio, $1 must be equity for every $2 borrowed from banks or vendors. Companies that fall short are considered undercapitalized.

Fortunately, there are alternatives to the conventional criteria.

Asset based arrangements

Businesses that have operated for many years often have built up substantial collateral, such as owned real estate. These businesses may be unable to satisfy the cash flow requirements of conventional lenders. Or, if the business was recently acquired, it may be short on capital. In these situations, asset based lenders are an excellent option.

Asset based lenders take higher risks because of their focus on collateral. In return, their interest rates are somewhat higher than those of conventional cash flow lenders.

They also monitor loans much more closely and require frequent collateral reporting. Their advance rates generally follow those outlined for conventional lenders.

In more extreme situations, asset based lenders do not go far enough in terms of their risk tolerance. Other types of lenders may be able to relax cash flow and capital requirements even more, while offering higher advance rates. Ultimately, lenders actually take title to assets themselves. For accounts receivable, the arrangement is known as factoring.

But selling assets also applies to larger things that the company needs in order to operate. Equipment and real estate can be sold to and then leased back from third party investors.

Many of these are private investor groups that have raised funds just for this specialized purpose. The availability of these funds enables businesses to free themselves of more onerous arrangements and, for real estate, to obtain time to shop for less expensive facilities.

A company for which sale-leaseback of equipment worked particularly well was one entering the automotive industry as a tier one supplier. The process entailed long lead time between order and production. Much of this time was spent tooling up and investing in expanded staff and facilities. Naturally, the result was projected operating losses until this new business started. A conventional bank could not see past the months of anticipated negative cash flows.

An equipment lessor, however, could be much more collateral focused. The ultimate structure allowed the company to sell the equipment to the lessor for 100% of its cost and to lease it back for five years, returning it to the lessor at the end of the term at a reasonable rate of interest. If the company wished to purchase the equipment at lease end, the effective interest rate was significantly higher. But then again, the desire to purchase would mean that the new program had been successful, and that there would be plenty of profits to spend. In this manner, the arrangement reduced the risk to the company.

Cash flow alternatives

Less established companies may have significantly fewer assets to offer. Because of their kick of collateral, they likewise have trouble obtaining conventional financing. Often, however, they have cash flows that can attract alternative lenders.

The major sources of funding that focuses on cash flow are providers of subordinated debt or mezzanine financing. They measure cash flow using EBITDA, or earnings before interest, income taxes, depreciation, and amortization. They view their niche as being able to provide a layer of financing over and above what the collateral advance rates support.

For example, a conventional bank would prefer to keep its loans at less than the borrower's EBITDA multiplied by three. If a borrower has EBITDA of $1 million, for example, lenders would rather not provide more than $3 million. Providers of subordinated debt or mezzanine funding, on the other hand, are willing to raise the multiple to four with another $1 million in debt.

While both subordinated debt and mezzanine are subordinated in their liquidation preference to conventional senior loans, the latter adds an equity component. This may take the form of warrants to purchase shares or interests in proceeds upon the eventual sale of the company.

Taken to another level, the next step after mezzanine providers is raising equity capital. Venture capital or private equity firms allow companies to do this without the enormous costs associated with a public offering of shares. In return, they seek returns ranging from 25% and up.

Factors are a different breed of lender, but pose their own difficulties. An outgrowth of collection agencies, factors specialize in collecting receivables. They buy a company's receivables and then bet on their ability to collect more of them at a faster rate than the original owner. Personal claims such as car loans are often sold to factors, as are trade receivables from small suppliers that sell to big companies. (In fact, factoring in this country was born out of the apparel business at a time when the big department stores were a financially solid risk and their suppliers were small garment manufacturers.)

Factors are not keen on nursing homes because nobody, least of all they, can rash the government when it comes to paying up. As a result, factors are not major players in the

 

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