We often tell our clients that a company does not file for bankruptcy on a particular day because it has too much leverage, or because it has a bad management team, or because it has a competitive disadvantage. All of these factors may eventually drive a company out of business, but the reason a company files for bankruptcy on a particular day is liquidity: they run out of cash. Therefore, it is important to measure a company’s liquidity as part of any comprehensive financial analysis (one of our favorite tools is the liquidity position).
For many companies, availability under a committed, revolving line of credit is a key source of liquidity. Here’s an example:
In 2010, Sears Canada entered into a five-year $800 million senior secured revolving credit facility. As of January 28, 2012, they had borrowed $101 million under that facility. How much additional can they borrow using that revolver?
a) $699 million
b) zero
c) Something between $699 and zero
The answer is … you don’t have enough information to give an answer. According to Sears, they have $415 million available.
Here are the factors that determine how much you can borrow on a revolver:
- How much you have already borrowed. In the Sears example, it would reduce availability to $699 million
- Letter of Credit usage. Many revolvers can also be used for letters of credit. This allows companies to issue letters of credit without getting credit approval for each one individually. However, letters of credit issued under a revolver reduce borrowing availability under that revolver. In the Sears example, they had approximately $284 million of letters of credit outstanding under the revolver. When added to the $101 million of borrowings, it reduce availability under the revolver to $415 million.
- Covenants. If a company is in default under its credit agreement (for example, because it breached a covenant), it automatically blocks any additional borrowing under a revolver (because it can not satisfy the “conditions to borrowing,” one of which is an absence of default). In addition, if the borrowing itself would put the company into default (for example, by increasing leverage above the leverage covenant), the company may not borrow. In our example, Sears is not in default (but if they were, the answer would be zero). It is interesting to note that a default does not automatically require the company to repay the existing borrowings – lenders must affirmatively act to accelerate (or “call”) the loan.
- The Borrowing Base. According to Sears, “Availability under the Sears Canada Facility is determined pursuant to a borrowing base formula based on inventory and account and credit card receivables, subject to certain limitations.” So even if there were no borrowings and no letters of credit, and even if the company was in compliance with all covenants, they might not be able to borrow the full amount of the facility, because of the borrowing base.
Here’s how a borrowing base works:
- Review the company’s accounts receivable and inventory. Are there any items that are likely worthless (e.g. past due, disputed or related party receivables; obsolete or work-in-process inventory) or unable to be pledged (e.g. inventory or receivables in other countries)? These items are referred to as “ineligible” and are removed when calculating the borrowing base.
- Apply an “advance rate” or discount to the remaining “eligible” items. This discount reflects the likely decline in asset values in a stress scenario and the cost to the lender to foreclose and sell the collateral. Typical advance rates are 50% for inventory and 75% for accounts receivable.
- Once the ineligible items are excluded and the advance rate is applied to the remainder, you end up with the borrowing base amount. The revolver must, at all times, be at or lower than this number (even if it is less than the stated amount of the revolver). For Sears, the borrowing base was not a limitation (i.e. the borrowing base was larger than the commitment amount). Here’s an example of how a borrowing base might work (not Sears):
Asset based lenders (“ABL”) use a borrowing base all of the time. It is also very common among small and middle-market borrowers. It is typically not used for loans to large corporate borrowers (except if they are borrowing in the ABL market).
So how much can a company borrow under its revolver? It depends.
Why would a company choose to borrow from an asset based lender and choose to subject themselves to a borrowing base?
Thanks for your question. While the reporting requirements for ABL are typically more onerous, asset based loans typically have fewer covenants. As long as the company keeps a certain amount of availability on the loan (e.g. the borrowing base exceeds the loan outstanding by at least 10-20%), there may be no financial covenants. For many borrowers, this added flexibility makes up for the additional reporting burden.
I thought this was a very interesting article and very similar to what I have experienced in Canada for some mid market type accounts. I just wanted to add a few points and others can chime in with their opinions.
Firstly, a bank is interested in knowing that it can be repaid. Secondly, it likes to see the short term revolver fluctuates up and down, thus evidencing the collection and use process of the revolving line of credit. The revolving line of credit was often based on the needs of the client and on cash flow projections submitted by the client. These needs would then be measured as a function of the working capital of the company. A rule of thumb would be two times the working capital, but this would be dependent on the industry, and the composition of the company’s working capital. If the working capital was insufficient, additional security would be requested, or an injection of capital. Borrowing base conditions were then put in place based on eligible accounts receivables and inventory. Usually this would be 80% on AR and 25% to 50% of the inventory depending on what type of inventory the company held, and the turnover rate of the inventory. Covenants were also put in place, and the company was required to send in monthly declarations attesting that the credit conditions were respected.
An analysis of the monthly reporting figures and as well the annual and/or interim financial statements was made to ensure that the credit conditions were respected, and that there was no deterioration in the company’s financial base. Some banks and ABL would also have internal audit teams which visited the clients on a regular basis to ensure that the underlying security was adequate to cover advances, and that there were no irregularities which could jeopardize the the loans, and lead to losses.
Naturally every case is unique in itself, and conditions could vary between borrowers. In a case like Sears, I would definitely like to be comfortable with the cash generating abilities of the borrower (inventory turnover).
As I credit professional, I found this article to be well written and to the point. Many small business owners do no not understand the covenants in their loan documents. This may be because their loan officer did not explain adequately or the owner relied too heavily on their CPA to manage. Either way, understanding borrowing bases and covenants are key to maintaining a line of credit. As a special assets officer, I saw lines called to the great surprise of the borrower who thought that the line would be available year after year with no regard to covenant exceptions.
One very large bankruptcy example that was not caused by illiquidity on a given day:
http://blogs.wsj.com/deals/2011/11/29/analysts-react-americans-bankruptcy-filing-this-wasnt-about-liquidity/
The previous comment (American Airlines) is a great example of when a company filed for bankruptcy even when it had lots of cash (thanks for the comment, David). While this is rare, it does happen. To get through the bankruptcy process, companies need cash. Many companies get this cash through a combination of DIP financing (i.e. a special kind of loan for companies that are in bankruptcy) and/or exit financing (a loan or bond that is done when a company exits bankruptcy). During the recent downturn, the availability of DIP and exit financing dropped considerably, making the bankruptcy process harder for many companies. American Airlines avoided the need for DIP financing for filing when it still had a strong cash position.
Thanks for sharing that article. When I review Companies, I am very leery of Companies using an Asset back facility. There are too many thing I NEED TO KNOW that they are most likely not willing to share, at least on the private companies. I find that these are becoming more and more prevalent here in the US.
Interesting. In Spain, and according to bankruptcy law (obligor protection scheme, rather, as Spain is an obligor friendly regime), the bankruptcy administrator can make full use of a credit line even after a default. This is because the bankruptcy state is considered to be a transition state aimed at curing the impaired firm.
In response to why a company would want to subject themselves to an ABL facility, one reason might be that the company is asset-rich but cashflow-poor. In this instance, it could borrow more under an ABL facility than it would be able to do under a ‘normal’ cash flow lend.