Avoid Pitfalls in Asset Based Lending ( for banks )

1. Bob Grant’s….
April 2011
T IMELY T OPICS
Rgrant56@gmail.com
248-321-1405
Avoiding Pitfalls in Asset Based Lending
(Asset Based Lending-Lite)
As banks look to diversify from concentrated levels of will be collected.
CRE lending, a renewed interest in traditional
Commercial and Industrial lending has developed. Pre-billings: arise when a borrower issues
My formative years were in C & I lending, so I thought accounts receivable invoices before they have
I would provide a quick refresher on a few of the key shipped products or services. Often times this
elements of asset based lending. Not pure asset occurs at a quarter or year-end in an effort to
based lending, where the highly leveraged balance accelerate revenue, but it can also be done simply
sheet is viewed acceptably, and where specific invoice in an effort to accelerate cash flow by a borrower
financing occurs, but for more moderate risk profiles. with thin working capital. Regardless, pre-bills
should be excluded from any borrowing base.
A borrowing base (advance formula) typically governs Pre-bills often go undetected unless there is a
a line of credit where line advances are made against field audit.
a percentage of eligible accounts receivable, and
sometimes against a typically lower percentage of Other: contractor receivables are an obvious one,
inventory. The quality and proof of accounts due to the Michigan Builders Trust Fund Act.
receivable is critical and should be validated by a pre- Agency receivables are another type to watch out
funding audit (and preferably some regularly for (insurance agents, the media portion of
scheduled audit thereafter). These field audits are advertising company receivables, etc.). Highly
often performed by third party professionals with the concentrated, foreign sourced and certain
costs being absorbed by the borrower. A government receivables may be ineligible.
rudimentary view of what to look out for includes:
Work in Process Inventory: Should be excluded
Accounts Receivable Dilution: essentially any portion from your borrowing base. This is often a real
of accounts receivable identified as going issue with companies that have longer cycles like
uncollected. Discounts, returns, chargebacks, trade
machine builders, transfer lines and other
allowances, bad debt, etc. all dilute the quality of the
“project” related inventory.
accounts receivable and need to be excluded from
the eligible receivables.
Common issues that are identified through field
audits include: Dilution and its calculation,
Progress Billings: the goods or services being
flexible accounts receivable terms not properly
provided are not complete, but partial billings are
disclosed, the over estimation of inventory
allowed. Obviously, should the bank be in a position
values, poor inventory controls, and inadequate
where it needs to collect the receivables, collection on
inventory testing.
unfinished goods or services is highly unlikely, at
best. While the customer may truly need the good or
Other fundamental issues that should be
service, the fact that there have been progress
considered are balance sheet leverage, the level
payments make it unlikely that any further amounts
of trade payables and other accrued expenses.

2. Page 2 Timely Topics
A few other thoughts on lending against inventory. Of course, you do need to build a monitoring
Do so selectively. Is there good gross margin in the system to assure proper line advance controls are
product? If it is a very low margin product, arguably in place. Typically, banks require a borrowing
the risk of lending into inventory increases. One base certificate, accounts receivable and accounts
way of dealing with that is to maintain a lower payable agings on a monthly basis, though bi-
advance rate. Generally, we are dealing with fewer weekly or weekly may be required for some
Audited Financial Statements which increases the accounts. Obviously, the monitoring system
risk of the value of inventory presented in the should have independence from the relationship
financial statement. You can require a “special manager and should provide alerts to appropriate
procedure” where you have the accounting firm management if there is an “out of formula”
specifically do inventory testing of some level. Still, occurrence or the account hits predetermined
a qualified field audit should be done at least at the triggers.
time of original funding to build a baseline of the
real inventory risk. There are several very competent field auditors
based in Southeast Michigan. Of course a number
Be aware of lending against specialized products
of accounting firms will do field audits, though
that are saleable to only a limited number of buyers.
their levels experience varies quite a bit. I have
Also, don’t underestimate the obsolescence
used Lender Solutions, Inc. a number of times and
risk…there is almost always some inventory that is
find them responsive, flexible and knowledgeable.
not of real value. Finally, if inventory is housed at
Contact Theresa Zitkus at 248-442-9600
several locations, be alert to the increased risks and
(www.lendersolution.net). I also know that Plante
the even greater import of good inventory controls.
& Moran does some field audit work and I have
used them for ‘special procedures’ on several
I know you won’t forget that personal guaranty. occasions.
While the guarantor may or may not have the
wherewithal to pay on the loan, the guaranty may be
important in helping you collect accounts receivable
or convert select inventory in to saleable inventory if
things go awry.