Given the unprecedented events that have unfolded in our financial markets in recent weeks, the issue of risk management has become a topic of much discussion. Most community banks, including CNB, have steered clear of the credit problems encountered by other institutions by maintaining consistent underwriting standards, including a focus on primary and secondary sources of repayment.
When evaluating a loan request, lenders focus first on the primary source of repayment (cash flow). Since most lenders seek a secondary source of repayment, collateral and/or guarantees of the owners of the business are often required as part of the loan approval. Obviously businesses with established histories of positive cash flow combined with low debt-to-equity positions and high levels of net worth may be able to obtain financing with less collateral than would be required from a newly established business or a business with a higher risk profile. Since most business loans involve some form of collateralization, business owners may find it helpful to understand how lenders place values on the assets that a business can offer as collateral.
The relationship between the enterprise value of a business and the collateral value of the assets of the business is an important concept. The enterprise value of a business represents the value of the business if it were to be sold as a going concern and may be expressed as a multiple of cash flow, a multiple of a certain annual revenue stream (such as annual premiums collected by an insurance agency) or simply as the price that a third party may be willing to pay for the business. Collateral values, on the other hand, are the values of individual asset classes of the business, usually consisting of accounts receivable, inventory, equipment and vehicles.
Other assets such as real estate or marketable securities, while not included in the traditional definition of business assets, are also frequently used to secure bank borrowings. In some cases, personal assets of the business owners may also be used to provide additional support.
The enterprise value of a business is often greater than the collateral value of the assets of the business, and lenders may not be willing to extend credit based solely on the enterprise value of a business, especially if there is a significant difference between the enterprise value and the bank's estimate of the value of the underlying tangible assets of the business. Subordinated loans provided by former owners, nonbank lenders or investors are often used to bridge the gap between the enterprise value or selling price of a business and the amount of financing provided by a bank.
Loan programs or guarantees available through local economic development agencies, government agencies or development companies may also be used to provide loans with higher loan-to-value ratios or more flexible payment terms than may be available under traditional lending parameters.
Since bankers want to understand what the assets pledged by a borrower might be worth at some point in the future, historical data is used to forecast what different types of assets may be worth if those assets were to be liquidated (either by the borrower or the lender) and used to repay loans incurred by the borrower. Most banks use current financial statements as the basis for their evaluation of business assets, however, adjustments (both positive and negative) often need to be made to arrive at realistic collateral values for these assets. Ranges of value for business assets most often used as collateral are detailed:
Accounts receivable are valued at 65 - 80% of the balance shown on financial statements or accounts receivable agings, assuming the statements or agings are relatively current. Lenders typically exclude foreign accounts and accounts greater than 90-120 days from invoice when valuing accounts receivable, and higher discount percentages may apply if the business exhibits a history of significant bad debt expense or large sales concentrations with one customer.
Inventory can show a wide range of value. Retail inventory or finished goods that can be readily sold to third parties may be valued at up to 40-50% of the balance shown on recent financial statements; conversely, inventory consisting of work-in-process or obsolete goods might have little or no value in a liquidation scenario.
Equipment, furniture, fixtures and vehicles also show a wide range of values and are difficult to evaluate using only financial statements since the depreciation schedules used in financial statements or tax returns may differ from the useful life of the asset. Because the age, condition and obsolescence of these assets are critical components of their value, physical inspections combined with the use of appraisals or third-party valuation guides are often the best way to arrive at realistic collateral values for these items.
Real estate, whether used to secure a conventional mortgage loan or used as supplemental collateral for another type of loan, is usually valued at 70-80% of its current market value. Federal and State banking regulations require that banks obtain independent appraisals to support most real estate related transactions. The pledge of cash or marketable securities as collateral, while not a viable alternative for many business borrowers, can result in more flexible repayment terms and lower interest rates than may be available in traditional financing structures. New businesses that do use cash or marketable securities to obtain financing are often able to substitute other types of collateral once a track record of profitable operations has been established.
Intangible assets could include intellectual property, customer lists or goodwill. While these types of assets undoubtedly contribute to the overall enterprise value of a business, placing a collateral value on them is a challenge for lenders, particularly in a liquidation scenario. As our local economy moves toward a greater reliance on information based technology, it will become increasingly important for bankers to become more comfortable with the value of these types of assets.
In summary, while an abundance of security or collateral alone (except in the case of cash or marketable securities) may not be enough to convince a bank to extend credit, the combination of adequate cash flow and reasonable collateral coverage should provide the foundation for a mutually beneficial banking relationship.
Gary Babbitt is Executive Vice President, Commercial Services. Gary can be reached at (585) 419-0670 ext: 50645 or via email at email@example.com