Collateral: Do you have enough?
You know you’ve got a great business. You’ve got good people, who are loyal and work hard to help your business grow. You have a well-made, thoughtful, and competitive good or service. The market is ready for you and you have found your niche in it. It is time to grow your company! Now you just need a little money to find more customers, obtain more inventory and expand your footprint.
There are many types of lenders out there, but almost all are looking for something to protect themselves from credit risk. In other words, if they loan you money, and you don’t pay it back, what else is there to help absolve the debt? This is called collateral. And while there are lots of different types of collateral, a good business idea and loyal employees usually don’t qualify.
What is collateral?
Collateral is any asset that can be pledged against a debt. Should the debt payments not be made, the lender can repossess the asset, sell it, and be repaid for their debt. Lenders typically do not loan against the full value of the asset, since they may have to sell quickly, in not ideal conditions, or with costs associated.
Think of a home mortgage. The bank lends you money, you purchase a house. If you do not make your payments, the bank repossesses the house, sells it and then pays off the loan.
Common forms of collateral are land, buildings and equipment. But, it is also possible to have collateral that is more liquid, but still worthwhile, such as inventory and accounts receivable.
How is collateral valued?
Many types of collateral can be valued through an appraisal. Since values of fixed assets typically change slowly over time, lenders will have a requirement for how often these values need to be reevaluated.
For more liquid assets, such as accounts receivable or inventory, which can change daily, collateral is often monitored using a borrowing base. A borrowing base is a document that records all the assets as of a certain date, and then uses a discount percentage to come up with available credit.
Borrowing Base Example
Say your agreement allows you to borrow up to 80% of both your inventory on hand and any outstanding accounts receivable you have invoiced but not received payment on that is less than 90 days old.
Accounts Receivable: $120,000
Discount %: 80%
Total Available Credit: $136,000
Current Borrowing: $50,000
Current Available Credit: $86,000
Once the total collateral is added up, it is multiplied by the discount percentage. Essentially, a lender will not give you 100% of the value of your accounts receivable or your inventory, because in the event they had to liquidate these assets, it’s unlikely they could recoup the entire value. This arrives at a total credit calculation. Then, what you have already borrowed is subtracted out to leave only the remaining available to borrow.
These borrowing bases are updated frequently to keep the lender in the loop on how collateral is moving and changing.
Even if your business does not have land or buildings, it is still possible to have enough collateral to secure a loan. Working capital loans, lines of credit, factoring and asset based lending can all use liquid assets to infuse capital into the business, even with a lack of hard assets. Understanding the full value of the assets on your balance sheet is the first step. Be prepared to discuss this with any financier you approach!