Business Finance | What if our loan collateral doesn’t cut it?

A Weekly Business Finance series for Non-Finance Executives!

“Financial Adrenaline” is a term we love around here because it reflects our commitment to help you turbocharge your business with practical tips and techniques to improve free cash flow, the lifeblood of business. As a further extension of our Financial Adrenaline program, we’re going to share a new Business Finance Tidbit every Wednesday specifically for those business executives who don’t have a finance background. Our current Big River series started with We’re Making Money. Why are we broke? … and continued last week with No Cash? Can we borrow what we need?

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“Anyone who lives within their means suffers from a lack of imagination.”

Oscar Wilde

Where do we start?

Tom Sampson, the controller for Ace Business Stuff, was in his office considering how to explain to John Wilson, the Company’s CEO, the issues related to the Company’s borrowing capacity and the weaknesses in the Company’s Balance Sheet.

Tom pulled together several schedules for his meeting with his CEO that afternoon, but was still struggling with how to get across some of the subtleties that he knew John would want to understand. Tom knew that his CEO was absolutely committed to the Company’s success, yet became very frustrated when his convictions about future performance collided with the bank’s concerns about current performance.

What factors will the bank consider?

Tom knew that the bank considered many factors when judging an asset-based loan. Having enough collateral to support the Company’s borrowing request was only part of it.

How do they measure the strength of the collateral?

One key ingredient is the quality of the collateral. Tom had often expressed concerns about the Company’s liberal return policy, as well as its lenient collection policy. He knew the bank would examine the Company’s historical product return rate and its collection policies and they might fall a little short.

What is the quality of our receivables?

It was likely that the generally-accepted 80% advance rate against receivables would be reduced by the bank given the Company’s product return rate of around 7%, meaning that the Company only netted about 93% out of every sales dollar. Tom knew that the return rate was unacceptably high and while they were working on it, they hadn’t made much progress.

Is there any bad debt expense?

Also, their bad debt expense was 5% last year because they failed to uncover a struggling customer before they went out of business. The bank would calculate that the 93% value of every sale is really more like 93% minus the 5% bad debt, which brings the realizable value from each dollar of sales to something like 88%.

Tom was pretty sure that the 8% margin over the target 80% advance rate would not give the bank a sufficient cushion. Most likely, the company would be unable to borrow at an 80% rate … more likely, something like 70%, which would be pretty tight.

What about our inventory value?

“Hi Frank,” Tom said when he reached the Company’s warehouse manager. “John and I will be visiting with our bank next week and I wanted to get an update from you on some of the older inventory we still have on hand. Any movement on any of that?”

“Not really, Tom,” Frank replied. “I’ve reminded the sales guys every time they wander through here, and I know John has talked to David about it.” David is the company’s sales manager, a capable executive but one who, in Tom’s opinion, always looked forward to next season’s products without much accountability for inventory that remained unsold for the past season.

“Tom, you know John. Like the rest of us, he hates writing stuff off but some of this stuff, well, I don’t think the customers really want it anymore.”

What are you doing about slow-moving inventory?

“Thanks, Frank. I know I need to talk to John further about it. I’ll get back to you with whatever I learn.”

This is why their inventory turnover is declining, Tom thought. He knew that the sales department, with John’s tacit support, was unwilling to reduce prices on products that an outsider might consider obsolete, believing that they could be sold “if they could just find the right customer”.

They rarely did, so the inventory just sat there. Once the “salable inventory” was identified and examined by the bank, the common 50% advance rate for inventory might also be under attack.

Are you paying enough attention to your balance sheet?

Tom considered various ways to overcome these issues but also realized that the Company’s Balance Sheet was also working against him. He didn’t have a current schedule handy, but he knew he needed to update their various ratios so he could show John, in black and white, exactly what was going on.

What are some of the ratios the bank cares about?

Tom knew that their Current RatioA liquidity ratio that measures a company's ability to pay short-term obligations. It is a well-established measure of a company’s liquidity, which divides Current Assets by Current Liabilities to evaluate whether the current liabilities could be paid as current assets are converted to cash. A higher number demonstrates the Company’s superior ability to generate cash to pay its short-term obligations. The Current Ratio is also known as the 'liquidity ratio', 'cash asset ratio' or 'cash ratio'. was tolerable but not great. He also realized that a greater concern would be the Quick RatioAn indicator of a company's short-term liquidity. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company. The quick ratio is calculated by dividing the net amount of (Current Assets - Inventories) by the amount of Current Liabilities. This ratio is deemed a closer measure of liquidity, referring to how quickly the Company can generate cash. Since inventory has to be sold before a receivable is created, the Quick Ratio shows whether a Company is likely to struggle with its current obligations if its inventory is not sold on a timely basis. Also known as the 'acid-test ratio' or the 'quick assets ratio., which was not very strong, barely half the size of the current ratio.

To be forewarned is to be forearmed

A lot was on the line. They weren’t just asking for a collateral loan. It was a balance sheet loan, too, and Tom hadn’t even dealt with those issues yet.

“John,” Tom said when he called his CEO and got a voicemail recording. “I’ve got a few more things I’d like to prepare for our meeting, a few more schedules I’d like to put together. I’d like to push our meeting out by 24 hours so I can be better prepared and show you a more comprehensive picture.

“I’ll give you a call in the morning to reschedule our meeting.”

Do your homework

Have you carefully prepared for your meeting with the top executives in your company? Will you “bring it” when you meet with your bank or will they find you stumbling around for answers that you should know cold?

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What’s next?

This is Part 3 of a 12 part series called the “Big River“. For me, Big River signifies the growth path that so many companies follow, or are seeking, and the dangers that lurk along the shoreline as the Big River races forward trying to consume everything in its path. Next week you’ll learn how to begin to evaluate your bank borrowing capacity.

Did this stimulate your thinking? Want more?
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