Asset-Based Financing Basics

Asset-Based Financing Basics

Once
considered financing of last resort, asset-based lending and
factoring have become popular choices for companies that do not have
the credit rating or track record to qualify for more traditional
types of financing.

 

In
general terms, asset-based lending is any kind of borrowing secured
by an asset of the company. This article will consider asset-based
lending to mean loans to businesses that are secured by trade
accounts receivable or inventory.

 

Asset-based
lenders focus on the quality of collateral rather than on credit
ratings. Borrowers pledge receivables, inventory and equipment as
collateral. Traditional bank lenders may have significant problems
with asset-based loans. Banks are constrained by both internal
credit granting philosophies as well as federal regulations. Banks
typically do not accept transactions with debt-to-worth ratios
higher than four or five to one. Asset-based lenders that are either
nonbanks or separate subsidiaries of banks are not subject to such
constraints. This gives asset-based lenders the freedom to finance
thinly capitalized companies.

 



Editor’s note: After reading this article,

click here
for step-by-step examples, including footnote disclosures, for
GAAP treatment of factoring agreements, lockboxes and acceleration clauses.

 


REVOLVING
LINES OF CREDIT (REVOLVERS)

A
revolver is a line of credit established by the lender for
a maximum amount. Revolvers are used by retailers, wholesalers,
distributors and manufacturers. The line of credit typically is
secured by the company’s receivables and inventory. It is designed
to maximize the availability of working capital from the company’s
current asset base. A typical term for a revolver is one to three
years or longer. The borrower grants a security interest in its
receivables and inventory to the lender as collateral to secure the
loan. In most cases, lenders require personal guarantees from the
company’s owners.

 

The
security interest creates a borrowing base for the loan. As
receivables are collected, the money is used to pay down the loan
balance. When the borrower needs additional financing, another
advance is requested.

 

The
borrowing base consists of the assets that are available to
collateralize a revolver. It generally consists of eligible
receivables (defined below) and eligible inventory. The size of the
borrowing base varies with changes in the amounts of the borrower’s
current assets limited to the overall revolving line of credit. As
the borrower manufactures or acquires new inventory, and as it
generates receivables from sales, these new assets become available
for inclusion in the borrowing base.

 

The
borrowing base certificate is a form prepared by the borrower and
submitted to the lender periodically (usually monthly). It reflects
the current status of the lender’s collateral. This certificate
should be compared to the balance sheet for consistency.

 

Within
the overall line of credit, there can be a sublimit for letters of
credit. For example, an asset-based lender may grant a company an
overall line of $16 million, which includes $2 million for letters
of credit and $14 million for loans collateralized by the
receivables and inventory. Letters of credit are usually necessary
when a company is making purchases from a foreign vendor who
requires a guarantee of payment.

 


USE OF A LOCKBOX

A
typical agreement gives the asset-based lender control of the
company’s incoming cash receipts from customers. A “lockbox” or a
“blocked account” is established by the lender for the receipt of
collections of the accounts receivable. The lockbox account usually
is created at the bank where the borrower does business. The
company’s customers are instructed to pay their accounts by
mailing remittances to the lockbox. These payments are deposited
in a special account set up by the lender. The lender credits
these funds against the loan balance. The lender then makes new
advances against the “revolver” as requested.

 

A
revolver differs significantly from a term loan. As discussed, the
loan balance in a revolver typically is secured by receivables and
inventory, which can fluctuate daily. With a term loan, the
outstanding balance is fixed for a period ranging from a month to
several years. A term loan has an agreed-upon repayment schedule.
Generally, once an amount has been repaid in a term loan, it cannot
be reborrowed. In a revolver, however, the company can borrow, repay
and reborrow as needed over the life of the loan facility.

 


ELIGIBLE ASSETS

Not
all receivables qualify for inclusion in the borrowing base.
Examples of receivables that would be ineligible are receivables
that are more than 90 days old and related-party receivables.

 

Borrowing
against or factoring U.S. Federal Government receivables is subject
to the requirements of the Assignment of Claims Act of 1940 (see
“Other Resources”). There may also be restrictions on receivables
generated from foreign sales and receivables to companies that both
buy from and sell to the borrower.

 

In
general, eligible inventory includes finished goods and marketable
raw materials and excludes work-in-process and slow-moving goods.
There also could be limits on the advance rate for specially
manufactured goods that can only be sold to a specific customer.



 



Advance
rate.

The
amount that can be borrowed is based on the advance rate set by the
lender. The advance rate is the maximum percentage of the current
borrowing base that the lender can make available to the borrower as
a loan (see Exhibit 1 for an example).



 



Dilution
of receivables.

Dilution
of receivables represents the difference between the gross amount of
invoices and the cash actually collected for such invoices. Factors
such as bad debt write-offs, warranty returns, invoicing errors,
trade discounts and returned goods all are involved in computing
dilution. Dilution is expressed as a percentage. Dilution is
important because, as mentioned, the lender uses it to establish the
advance rate (see Exhibit 2 for an example).



 



Credit
insurance.

An
insurance company provides an asset-based borrower with an insurance
policy covering the receivables. It is common for asset-based
lenders who are financing companies in certain industries, for
example, the retail industry, to require credit insurance. The cost
of credit insurance is relatively modest. Credit insurers may
decline to insure certain customers.

 


PURCHASE
ORDER FINANCING

Purchase
order financing can be used by companies with limited working
capital availability who receive an unusually large order from a
customer and, as a result, need additional funds to provide
materials and labor to manufacture or supply its product.

 

In
this type of financing, the lender accepts the purchase order from
the company’s customer as collateral for the loan. These lenders are
willing to accept the added risk that the order will be completed,
delivered and accepted by the company’s customer. While the cost is
also higher than traditional asset-based borrowing, in some
circumstances—based on the profit margin for the company and
maintaining or establishing its relationship with the
customer—purchase order financing may be cost-effective.

 


FACTORING

Factoring
is a financial transaction whereby a company sells its accounts
receivable to a third party, the factor, at a discount to
obtain cash. Factoring differs from a bank loan in three
ways:

 

 

The
sale of the receivables transfers ownership of the receivables to
the factor. This means that the factor obtains all of the rights
and risks associated with owning the receivables. The factor also
obtains the right to receive the payments made by the company’s
customer for the invoice amount. As previously discussed, this
also occurs in asset-based borrowing. In nonrecourse factoring,
the factor bears the risk of loss if the debtor does not pay the
invoice.

 

There
are three principal components to the factoring transaction: the
advance, the reserve and the fee. The advance is a percentage of
the invoice face value that the factor pays to the selling company
upon submission. This is similar to the advance in asset-based
borrowing. The reserve is the remainder of the total invoice
amount held by the factor until the payment by the selling
company’s customer (debtor) is made. The fee is the cost
associated with the transaction that is deducted from the reserve
prior to its being paid back to the seller (credit guarantee). The
interest charge fee is calculated based on the advanced amount
outstanding, multiplied by the agreed-upon interest rate. The
factor will often add a surcharge for debtors who are not
considered creditworthy. The factor’s overall profit is the
factoring fees and interest charges less bad debts (if the
factoring is nonrecourse).

 

It
is a fairly common belief that factoring is too expensive, but
this is not necessarily true. It is well known that factoring is
more expensive than a bank loan. Factoring is a method used by a
company to obtain cash when the company’s cash liquidity is
insufficient to meet its obligations and accommodate its other
cash needs. A company sells its invoices at a discount when it
calculates that it would be better off using the proceeds to
bolster its own growth than it would be by effectively functioning
as its “customer’s bank.” Therefore, the trade-off between the
return the firm earns on its investment in production and the cost
of utilizing a factor is crucial in determining the extent that
factoring is used and the amount of cash the company has on hand.
In other words, whether to use factoring or traditional lending is
an important business decision. Sometimes in cases where a bank
will not extend credit, a factoring company will.

 

When
initially contacted by the company, the factor first establishes
whether a basic condition exists: Do the company’s customers have
a history of paying their bills on time? That is, are they
creditworthy? Note that a factor may obtain credit insurance
against the debtor’s becoming bankrupt and therefore not being
paid, similar to credit insurance in asset-based borrowing. In a
full-service factoring arrangement, the debtor is notified to pay
the factor, who also takes responsibility for collecting payments
from the debtor and assumes the risk of the debtor’s not paying in
the event the debtor becomes insolvent. This is called nonrecourse
factoring. Recourse factoring is typically less costly for the
company because the company retains the bad debt risk.

 


ACCOUNTING FOR FACTORING AGREEMENTS

When
a receivable is sold to the factor without recourse, the
balance sheet presentation is straightforward—account for the
receivable as a sale. When the receivable is sold with recourse
to the factor, whether or not the receivable is accounted for
as a sale or as a secured borrowing will be determined by
following the provisions of FASB Accounting Standards Codification
(ASC) Section 860-10-40.

 

Typically,
factors that are familiar with the provisions of U.S. GAAP will
purposely structure the agreement so that the transaction is
treated as a sale rather than a secured borrowing. This is crucial
if a company is mandated by loan covenants or otherwise to meet
certain ratios such as debt to equity and working
capital.

 

For
a step-by-step example that applies ASC Section 860-10-40 to
factoring agreements with recourse, click here.

 


ACCOUNTING FOR LONG-TERM DEBT
REVOLVERS

The
classification of long-term debt revolvers is an important
consideration when a classified balance sheet is presented because
asset-based lenders generally attach great importance to working
capital. Under certain circumstances, all the debt will be
classified as short term or long term. Under certain conditions, a
portion of the debt will be classified as short term with the
balance classified as long term. The proper accounting
presentation under U.S. GAAP depends on whether the agreement
provides for a subjective acceleration clause or a lockbox
arrangement.

 

A
subjective acceleration clause is a provision in a debt agreement
that states that the lender has the right to accelerate the
payments of the obligation under conditions that are not
objectively determinable. For example, the agreement may provide
for acceleration if the debtor fails to maintain “satisfactory
operations” or if a material “adverse change” occurs.

 

In
effect, if the lender feels uncomfortable, the line can be pulled
and repayment demanded. A lockbox arrangement can exist either in
an asset-based loan or in factoring. It provides that the
company’s customers must remit payments directly to the lender or
factor and such amounts received are applied to reduce the
outstanding debt or the amount advanced.

 

Where
there is a subjective acceleration clause and the likelihood of
the acceleration of the due date is remote (such as when the
lender historically has not accelerated due dates of loans
containing similar clauses and the financial condition of the
borrower is strong and its prospects are bright), neither current
classification nor disclosure is required. However, when an entity
is in poor financial condition, has had recurring losses, or has
liquidity problems, debt otherwise classifiable as long term that
is subject to such covenants shall be classified as a current
liability, unless the lender has formally waived accelerated
payment beyond one year. In other situations, disclosure of the
existence of such clauses is sufficient (see ASC Subtopic 470-10,
Debt—Overall).

 

Borrowings
under a revolving credit agreement may be classified as noncurrent
if the agreement extends for at least one year beyond the date of
the financial statements, even when the borrower intends to reduce
the amount outstanding. However, under certain circumstances, debt
issued under revolving credit agreements shall be classified as
current, even though the agreement runs for more than 12 months.
This would be the case where there is a maximum borrowing
base.

 


MAXIMUM BORROWING BASE

If
the maximum borrowing is tied to a borrowing base, the entity
shall make a reasonable estimate of the lowest borrowing base
during the next year. Any borrowings in excess of the amount
permitted at the estimated low point of the borrowing base shall
be classified as current (see ASC Subtopic 470-10). Consider the
following example:

A
company has $10 million of debt under a revolving line of credit
that matures more than one year from the balance sheet date. The
company estimates that during the upcoming year, it will repay
$2 million of the debt. Then $2 million of the debt will be
classified as current on the company’s balance sheet, and $8
million will be classified as long term. If, however, the
company does not intend to repay the loan during the 12 months
after the balance sheet date because it needs to reinvest in its
business, for example, if the company’s business is growing, the
company could estimate that there will be no repayments during
the current year. In that case, all of the $10 million of
outstanding debt would be classified as long
term.

If
the agreement requires that the outstanding balance be reduced to
zero at least once each year (cleanup requirement), all of the
borrowing shall be classified as current (see ASC Subtopic
470-10).

 

Borrowings
under a revolving credit agreement that contain a subjective
acceleration clause and also require a borrower to maintain a
lockbox with the lender (whereby lockbox receipts may be applied
to reduce the amount outstanding under the revolving credit
agreement) are considered short-term obligations. As a result, the
debt shall be classified as a current liability (see ASC Subtopic
470-10).

 

Note
that some lockbox arrangements do not go into effect unless the
lender exercises a subjective acceleration clause (a springing
lockbox). Long-term borrowings under such arrangements should be
classified as noncurrent, because the customers’ remittances do
not automatically reduce the debt outstanding. This would be rare.
The authors have never encountered a springing lockbox in
practice.

 

 


Click
here
 follow step-by-step examples, including footnote
disclosures, for GAAP treatment of factoring agreements,
lockboxes and acceleration clauses.

 

 


 


Exhibit 1 : Computation of the Advance
Rate

A
company has a revolving line of credit with an asset-based
lender for a maximum amount of $10 million. The agreement
provides for an advance rate of 85% of eligible receivables
and 60% of eligible inventory. The agreement provides that
eligible receivables consist of balances that are not over
90 days old and that eligible inventory consists only of
finished goods. The accounts receivable at the end of the
period is $5.5 million with $500,000 over 90 days old.
Inventory is $10 million of which $6 million is finished
goods. The borrowing base would be computed as
follows:

 

$  
4,250,000

b. Inventory
($6,000,000 x 60%)

3,600,000

c. Total
available

$   7,850,000

 

Because
the total available, $7,850,000, is less than the maximum
line, $10 million, and assuming that the company has
borrowed the total amount available, the loan is considered
to be “in formula.”

 

If
in the above example eligible receivables were $8 million,
the loan would be “out of formula” as follows:

 

$   6,800,000

3,600,000

10,400,000

10,000,000

$   400,000

 

A
typical agreement would require that the amount overborrowed
be immediately repaid to the lender. That amount would
generally be subject to a higher interest rate.

 


 


Exhibit 2: Dilution

A
company bills $1 million to its customers for invoices.
Of that, $930,000 is eventually collected. The
difference is $70,000 ($20,000 represents returned
goods; $5,000 is subtracted for prompt payment
discounts; and $45,000 is written off as bad debts). The
rate of dilution would be 7% ($70,000 ÷
$1,000,000).


 


 

EXECUTIVE SUMMARY


 



 
A revolver is a secured line of credit.

The
granting of the security interest to the lender
creates a borrowing base for the loan. As receivables
are collected, the money is used to pay down the loan
balance.

 



 
A “lockbox” or a “blocked account” is established by
the lender for the receipt of collections of the
accounts receivable.

The
company’s customers are instructed to pay their
accounts to the lockbox, and the lender pays down the
loan with these funds.

 



 
Eligible inventory includes finished goods and
marketable raw materials and excludes
work-in-process and slow-moving goods.

There
could be additional limits on the advance rate for
specially manufactured goods that can only be sold to
a specific customer.

 



 
Purchase order financing can be used by companies
that receive an unusually large order.

The
credit grantor accepts the purchase order from the
company’s customer as collateral for the
loan.

 



 
Factoring is a financial transaction whereby a
business sells its accounts receivable to a third
party, the factor, at a discount to obtain
cash.

Factoring
differs from a bank loan in three ways: (1) The
emphasis is on the value of the receivables, not the
borrower’s creditworthiness; (2) factoring is not a
loan—it is the purchase of the receivable; and (3) a
bank loan involves two parties whereas factoring
involves three.



 



Robert
A. Modansky


(rmodansky@rssmcpa.com)
is a partner and Jerome P. Massimino (jmassimino@rssmcpa.com)
is a senior manager at Rosen Seymour Shapss Martin
& Co. LLP in New York City.



 


To
comment on this article or to suggest an idea for
another article, contact Kim Nilsen, editorial
director, at knilsen@aicpa.org
or 919-402-4048.



 


 

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