Should a Borrowing Base Revision Ever be Reported?

I’m going to provide a quick answer now. I’ll save my reasoning for later in this discussion.

I’ve closed on about $400 million in bank financing in my career (that’s not a lot in dollars because I generally work with smaller businesses). My close rate is 100% on all financing projects I’ve worked on. Accordingly, I have never submitted an updated borrowing base report to replace the one I sent at the beginning of the month.

Had there been a situation in the past where an inventory error was detected and it detrimentally hurt my company’s borrowing base, I would have sent the revision after a lengthy discussion with my lender explaining the error and how to address a remedy if it caused our collateral to go under the bank’s threshold.

There’s another reason I might send an update, but let’s save this for the end after a refresher on borrowing base reporting.

Collateral and Discount Rates

Every young accounting manager who starts learning bank financing is quickly introduced to the 5 Cs of Credit. One of those Cs is collateral. Banks want to collect their interest each month and their money back at the pre-determined time pursuant to the financing contract that both parties sign for any loan.

While banks ensure you have the wherewithal to make timely bank payments, they want protection in case something goes wrong and you have the inability to pay back the loan. That’s why they ask for personal guarantees and collateral that must be pledged through state UCC filings (which protects a lender from other lenders loaning money to a business asking for collateral).

Banks want cushion on their collateral. They are conservative and will not accept collateral equal to the face of the loan. Instead, they discount the collateral. Once discounts are applied to each asset pledged for collateral, they will offer a maximum loan total. Such discounts are different for each asset class. Below is an example.

• Accounts Receivable – 80% on accounts that are not past-due
• Inventory – 50% for SKUs not greater than 180 days old
• Fixed Assets – 50% provided equipment is maintained and insured

Let’s assume an eCommerce business is seeking a $1 million line of credit. They have $1.5 million in good inventory that is sellable at full retail value. They could qualify for $750,000 using the above discounts, assuming the bank trusts their business model and cash flow. In this case, the business will have to get creative in funding the gap between what they need and what the bank will offer.

The Borrowing Base Fundamentals

Now that we understand collateral better, we can address reporting the bank wants for certain types of loans. For lines of credit, banks will offer a specified amount over a pre-determined time period, such as 12 or 24 months (12 months is the norm).

This face amount does not mean you have access to that total at all times during the term of the financing agreement.

Banks are smart. They know a lot about your business. They know that your AR goes up and down through numerous cycles inside a 12-month period. Inventory movement is even wonkier unless you sell groceries or serve as a distributor in that industry.

Accordingly, they never want your line of credit balance to exceed the discounted collateral value. Even if you have been approved for a $1 million line of credit, using the discounts above, if your aggregated collateral values fall under $1 million, that’s the maximum amount you can have drawn on your LOC.

Below is a visual example of a $750,000 line of credit where inventory is the primary collateral. That means the business, through its financial modeling, was able to demonstrate to the bank that the average inventory throughout the upcoming year would be $1,500,000.

In the fictitious yet realistic scenario below, the company’s collateral value has fallen below the maximum lending limit of $750,000 for several consecutive months. To clarify, while the face amount of the line of credit, in this case, is $750,000, the borrower cannot borrow beyond its collateral value (called the borrowing base).

Notice there are only four months that the collateral value (CV) exceeds the borrowing base (the book value of inventory multiplied by the discount rate). Does that mean the company above is hurting since the funds they can pull from the LOC are limited? No. That’s because cash flow is probably very good, assuming the drop in inventory correlates with their strong selling season.

Since I learned these borrowing base fundamentals early in my career, I went the extra mile once I started working with banks to secure my employers’ financing.

First, I modeled what I needed (even well after I received approval for a new line of credit). Remember this advice; the time to start working on your new line of credit increase is the first day after your approval of the current line of credit. That’s why accounting managers update their financial models every month.

Second, I created my own borrowing base reporting, which is far better than what the bank wants from you (I’ll explain their reporting requirements in the next section).

When I own the banking relationship, I go over this analysis with my lenders, who love it. For clients with whom I own the banking relationship, they understand the logic of sharing our analysis with the lender no fewer than four times a year. Hint: think credibility, which leads to something else as the relationship evolves. Here’s a page from my playbook:

In my borrowing base analysis pulled from one of many financial reports I’ve designed, notice three critical numbers:

1. the line of credit collateral value – notice there is plenty of collateral cushion
2. the calculated working capital need (that the accounting manager projects monthly going out 12 months)
3. the line of credit to working capital need – this number is incredibly critical to understand as the seasoned CEO can tell you that they have too much working capital they may have to finance on their own

The next section will address the bank’s borrowing base certificate. Don’t confuse it with the analysis above. Bank reporting doesn’t tell you if you have a problem now or will have one in the upcoming months. Skipping these fundamentals is like flying a plane through a cloud bank without instrumentation.

The Borrowing Base Certificate

Many banks require an account’s report in the form of a review or audit once the loan amount hits a certain threshold.

Whether they require a review/audit or not, they want some assurance you comply with the loan agreement requirements. They do that through a self-audit; in this case, it’s a borrowing base certificate.

Typically, it’s a spreadsheet where the business drops in AR and inventory balances using the applied discounts per the bank agreement. That total has to exceed what’s been borrowed on the line of credit but not exceed the loan amount. My banks require the CEO’s signature along with the accounting manager’s. They have the right to question any numbers on the certificate. The borrowing base certificate is also due monthly.

What happens if your collateral value is less than the borrowing base or exceeds the line of credit limit? Yes, you can do both. Yes, you can even pull more than your LOC bank contract specifies. Don’t worry; you’ll get a call to remedy the situation that day. How do I know this? Don’t ask, as I’m not telling.

Borrowing Base Certificate Revisions

I’ve never sent a revised borrowing base certificate for 25-plus years across some $400 million in bank financing. I’ve never needed to.

At the beginning of this article, I gave you a reason why I would immediately. If I found an inventory error that put the bank in a worse collateral situation, I’d update the report and send it after having a long conversation with the lender. By the way, every CEO I’ve ever supported would be behind me 100%.

In another situation, I might be tempted to send a revision, but only for certain posturing if our collateral was consistently hitting 95 to 100 percent of the borrowing base (it never should … if so, you have a serious capital issue that needs to be addressed immediately).

Let’s assume the collateral value has been greater than 95% of the loan value for 18 months in a row. These are bad financial optics. I couldn’t care less what your lender thinks. She may be happy you’re making interest payments on time. Over time, you will lose credibility with these types of numbers if they persist.

Let’s further assume that a cooperative elects to start paying an annual dividend based on prior member purchases, and you are entitled to $500,000 to be paid in 60 days. Let’s also assume we learned this information on the 15th of the month, but we were entitled to that money as of the prior month based on the way the cooperative calculates the special dividend.

In that case, I’m updating my balance sheet. If that receivable moves my collateral value to 75% of the borrowing base, you better believe I’ll send an update, but only after a conversation with my lender.

To summarize, my assumptions above are rare, and that means sending a revision will probably never be needed, as in my situation over the past 25 years.

The Beauty of the Borrowing Base Reporting

I had a bad attitude when I started submitting borrowing base reports to bankers. Even though I automated the process, it was still one extra step in administration, a form of waste that could be used in revenue-generating activities.

However, I hope you learned one silver lining in this process. I soon started turning the borrowing base reporting into an analytical tool. I started modeling my financial requirements regularly. I’d still be modeling without the borrowing base, but the banking requirement took my analysis to a different level.

While the purpose of this article was to address bank reporting revisions, don’t let the borrowing base reporting become just another activity to check off each month.