Bank Financing
A company with stable growth, revenues and cash flow and assets to serve as collateral can usually get bank financing. This is the least expensive form of capital. Banks charge interest rates keyed to various indexes. Interest costs have been low recently, and look to remain that way for the foreseeable future.
Bank financing documents can appear lengthy and complex, although the lending relationship is quite simple. After providing the funding, the lender is primarily concerned with receiving scheduled payments of interest and principal. The many protective clauses in the loan agreement are designed to maximize the lender’s chances of getting repaid in the event of a default and giving it an early warning if financial problems start to develop before an actual payment default occurs.
Companies often seek “asset based financing” from lenders. In this financing, a company borrows against its tangible assets, such as fixed assets, receivables and inventory. The amount available to loan is tied to the appraised value of assets or the amount of eligible receivables and inventory a company has at the end of a measurement period. The availability of funds for fixed assets is determined at the start of the loan, and the loan amount remains constant, subject to repayment through amortization. The availability of funds for liquid assets such as inventory and receivables is constantly changing. A formula is used to determine the exact amount of funds available to borrow. These borrowing limits are the critical measures of credit availability. Typically, borrowing limits don’t exceed 80% of the eligible receivables and 50 to 60% of eligible inventory.
A typical definition of an eligible receivable is one that arises in the ordinary course of business; is not disputed or subject to any right of set off, allowance or adjustment by the customer; is not more than 60 days old; and is owed by a customer whose financial condition is satisfactory to the lender in its sole discretion.
Eligible inventory has similar contractual limitations as to the quality, age and condition of the goods. Generally, a borrower must have a perpetual inventory system that keeps close track of inventory levels. The inventory may be subject to a fair market valuation if that measurement is lower than cost. Although these definitions and the discretion given to the lender to cancel the loan raise concerns, in practice the lender is subject to an obligation of good faith and fair dealing which tempers arbitrary lending practices.
The financing of accounts receivable is the linchpin of asset-based lending. Receivables are popular with lenders because they are self-liquidating and provide short-term sources of cash. The assets cannot be stolen, lost or damaged. However, problems can arise when the account debtor (the customer) has offsets or counterclaims against the borrower. These can compromise the collection of the receivable and reduce the lender’s collateral base. Lenders typically perform some due diligence on account debtors to make sure there are no hidden defenses to collection of the receivables.
Receivables financing is structured so that the account is immediately assigned to the lender without notifying the customer. The borrower merely acts as a conduit for the collection from the customer, and payments are applied directly to repayment of the loan. The lender monitors the collection of accounts daily and bases it’s lending on the amount of outstanding accounts. Another form of receivables financing is "factoring", where the receivable is actually sold to the factor at a discount to face value. The customer is notified that an invoice has been sold and the seller must repurchase the receivable if non-payment is due to a manufacturing problem. The credit risk is absorbed by the factor.
A typical loan agreement will cover the following topics, in a fashion that strongly favors the rights of the lender:
1. The interest rate, how interest is computed and how often interest is paid.
2. The schedule for repaying principal.
3. Any fees payable to the lender at the closing or during the term of the loan.
4. Affirmative covenants such as delivery of financial statements and other reports on a periodic basis; allowing inspections of major facilities and assets; payment of other obligations and taxes when due; compliance with applicable laws and maintenance of net worth and other financial ratios.
5. Restrictive covenants prohibiting the borrower from entering into merger or acquisition transactions; incurring other obligations for borrowed money; paying dividends or making distributions to shareholders; making loans to third parties or selling assets other than in the ordinary course of business.
6. Defining the events of default such as failure to pay interest or principal when due; breach of representations or covenants; and becoming insolvent or declaring bankruptcy.
To secure a bank financing, the borrower must provide credit supports, such as pledging specific assets or providing guaranties of third parties. A pledge of assets simply means the lender has a preferential right to be repaid out of the proceeds of the asset in the event borrower fails to repay the loan. The pledge is accomplished by granting a security interest in the assets, if they are personal property such as accounts receivable, inventory or equipment, or by granting a mortgage if the assets are land or buildings.
A guaranty is the promise of another party to make good on the loan if the primary obligor defaults. The guarantor may be a stockholder or subsidiary of borrower or some other company under common control with borrower. Most guaranties give the secured lender the right to pursue the obligation directly against the guarantor if the borrower defaults. There is usually adequate consideration for a guaranty if it is required by the lender as a condition of making the loan.
