Lenders such as Virginia Commercial Finance will use the 5 C’s of Credit as a framework to gather a more holistic view of the creditworthiness of a borrower. When looking at a potential borrower, lenders want to evaluate the risk of default. Using the 5 C’s, a lender can effectively measure the quality of the potential borrower and the loan. Through the 5 C’s of Credit, a lender examines a variety of factors before reaching a decision on whether to approve. As a business owner, you can increase your chances for loan approval by understanding the 5 C’s of Credit.
At a glance, the 5 C’s of Credit represent:
Character– broadly speaking, what type of person are you?
Cash Flow– the cycle surrounding the amount of cash coming into and out of a business.
Collateral- something you can pledge to back and secure a loan.
Capital- the amount of your own money you have embedded in your business. Conditions- the market conditions of your industry.
Collateral is what is promised by the borrower to secure repayment for a loan. If a borrower does not fulfill their loan payments, the Collateral may be liquidated by the lender. With an Asset-Based lender such as VCF, your Collateral can be leveraged to provide you with better and more flexible financing than a traditional lender. Although Collateral is not all that Asset-Based Lenders are focused on, this third C of Credit is extremely important because Collateral is the determinant used to advance funds to a business.
What Responsibility Does a Lender Have To the Borrower When Lending Against Collateral?
When a lender structures a financing arrangement with a borrower it is incumbent on the lender to ensure that the borrower’s cash flow can support the expense associated with the financing. Advance rates and lending structure must be properly established to ensure that the borrower can achieve their business goals and service the debt. The personal guarantors of the borrower and the lender have similar interests in that each wants to see the business succeed. By properly structing the financing based on the performance of the collateral the lender is helping to protect the guarantor’s interest. With the close monitoring of collateral performance, the lender is positioned to offer feedback and suggestions about the performance of the collateral for the benefit of the borrower and ultimately the guarantors.
What Important Qualities Do Lenders Look for in My Receivables Portfolio?
Lenders use formulas to look at the value of your Collateral and what kind of liquidity it can generate. With Asset-Based Lenders, the Collateral that will typically provide you with the greatest availability will be your Accounts Receivable (“A/R”).
Listed below are examples of what many lenders look for in your Receivables:
1) Granularity of your Customer Base. A Customer Base with high granularity is reasonably strong and sufficiently diverse. Many different types of businesses exist. There are companies that are very large and have only one customer, and there are companies that are very small that have thousands of customers. Concentrated Sales result when a large percentage of your sales are being generated from a single customer. If your sales are too concentrated, a lender may view this unfavorably. Lenders perceive the diversity of your customer base as a component of risk. If a customer who yields a very large percentage of your revenue experiences trouble, goes out of business, or switches to another supplier, this may adversely affect your own ability to pay back your business’ obligations. However, there are exceptions to every situation. If you have one or two large customers that are reputable, stable, and well established, then this can often mitigate the concentration risk.
In addition, the specificity of your customer data will be used by the lender to determine their credit worthiness. The more detailed your internal records and procedures are with regard to your customers, the higher the likelihood of obtaining financing becomes. If it is too difficult to determine the credit-worthiness of your individual customers, it can become difficult for a lender to provide funding to your business. Obtaining Credit Insurance for your company can help protect you on this front, and provide potential lenders the security they require regarding the credit-worthiness of your customer base.
2) Dilution and Aging of Receivables. Dilution is the difference between what you bill a customer and what you ultimately collect. More specifically, dilution is the total of the non-cash reductions to your invoices, such as discounts, credit memos, allowances, etc. Many businesses are under the impression that once their customers have been billed, it’s only going to be a few days before they collect. However, this is not always the case and a business’ working capital cycle can be significantly impacted by slow customer payments. In addition, the real question is not just when do you collect, but how much of what you are owed do you actually receive. Knowing the answer to this helps lenders determine an appropriate loan advance rate, with a margin of safety.
Dilution calculations necessitate lenders to examine the order taking process, invoicing, and collection policies of a business. The age of some Receivables may make them ineligible, meaning those receivables would not be used to calculate availability. For Receivables that have aged (remained outstanding) over a certain amount of time, you can assume a percentage of these obligations may never be collected. Historically speaking, when you sell someone on Net 30-Day terms, if an account is over 90 days, the probability of collection (statistically, over a very large pool) drops to about 5%. For this reason, when a Receivable goes above 90 days, it becomes risky to accept it as Collateral, and will most likely not be made eligible for you to borrow against. Most Asset-Based Lenders make Collateral eligible for 3x the time period of what the business’ selling terms are. For example, if you’re selling to customers with Net 30-day terms, typically the lender will make available for borrowing purposes the Receivables that are under 90 days.
Which Other Types of Assets Can Be Pledged as Collateral?
Inventory is another Collateral pool that lenders will advance funds against. In some situations, Inventory can be a little more difficult to lend against than Receivables. With Inventory, the lender is most likely taking on greater risk as Inventory is further away from cash than A/R and can be difficult to accurately determine its value. For this reason, when Inventory becomes a very large component of the Collateral pool for a VCF client, we typically require a professional appraisal.
However, there are many situations, as the world continues to evolve and develop, where Inventory is actually safer to lend to than Receivables. This is true for some businesses that:
1) Provide real-time reporting with electronic communication;
2) Hold Inventory in a third-party warehouse where the information is validated and documented by the third-party;
3) Have the type of commodity inventory that can be easily liquidated;
4) Have strong margins imbedded in the products they’re selling.
Generally speaking, a business’ Inventory will fall in one of three categories: Raw Materials, Work-in-Progress, or Finished Goods. Typically, a lender will make Work-in-Progress Inventory ineligible as it would require additional time and expense to finish this segment into a salable product. Finished Goods are usually considered eligible, provided they are located in a place where the lender can easily marshal and inspect those assets. Some lenders will also make borrowings available against the Raw Materials depending upon its composition and use. Situations vary depending upon the industry and the Inventory itself. In cost accounting, the cost of goods sold does not just include the direct cost of the Inventory. There is an allocation of overhead, freight in, and other costs that get added to the purchasing cost of the Inventory. Those are permanent values attributed to the Inventory. Then there are more technical cost measurement assumption terms, like LIFO, FIFO, or Lower of Cost or Market, that will all effect the value of your Inventory pool. It’s usual and customary to think that an Asset-Based lender may lend up to 40 -50% on eligible Inventory.
With this type of Collateral pool, a lender is going to want to know what the Inventory is comprised of at all times. Lenders such as VCF prefer someone who has Perpetual Inventory Records. This allows you to determine on a piece by piece basis, what is in the Inventory, the age of the Inventory, where the Inventory is stored, how long it has been there, what is the acquired cost of the Inventory, and what its value is now. When looking at a Perpetual Report, you would ideally be able to go out in the field and verify that everything in the report is actually there, the date of its arrival, its acquired cost, etc. Very proficient Asset-Based lenders are aware of how often the individual units within the Inventory are turning. Inventory turnover is also dependent upon the particular industry or the nature of the product. There are some industries where the Inventory turns over every 30 days, and there are some industries where it is normal for Inventory to turn over every 6 months.
How Can You Get More from Your Collateral?
The security of a loan backed by Collateral allows Asset-Based Lenders to make more cash available to you. At VCF, we can typically offer significantly greater cash availability than a traditional lender would be willing to provide. We feel confident in doing this because of the way we are able to monitor the Collateral through commercial field exams, borrower reporting, and financial analysis. Asset-Based Lenders are specialists who are experts at lending against a business’ short assets, such as A/R and Inventory. This often makes Asset-Based lending a great resource when you cannot secure the financing
your business needs, at the level of availability necessary, through traditional bank financing. Although a traditional bank offers financing at lower cost, Asset-Based Lenders can provide more leverage to a Collateral pool.
It is important to note VCF does not ask you to provide us with any information that you don’t already generate for yourself. Our Collateral examination process is not invasive and does not require a lot of additional reporting. Business owners are already aware of factors such as their daily invoicing, credit memo issuance, what comprises their Inventory and how often it is turning over, and how often their Receivables are being paid. Once a borrower is up to speed, it can take them as little as 10 minutes a day to provide us with the proper information.
If you have the Collateral to secure the working capital you require, consider asset based lending as the best option for you and your business. Take advantage of the opportunities you may miss by not securing the financing you need- contact VCF today at 804-897-1200.