Recently we encountered a situation in which a borrower had been working productively with its lender to sell one portion of the business and acquire a different, add on, business. All parties – borrower, lender, and investment banker – thought the changes would be good for the company and would significantly improve performance. About three months after the transactions closed, the borrower was in a serious over advance situation and began finding it difficult to maintain inventory levels required to support sales. Interestingly, the income statements looked like the company was performing as expected.
The company was performing as expected from a sales and margin perspective. What had been missed during the analysis of the sale of one business unit, and replacement of the revenues with sales from a new business unit, was the change in accounts receivable, inventory, and cash flow that was created by changing the make-up of the business. This change in the business impacted the accounts receivable turnover, which impacted cash flow. Additionally, both the inventory required and its turnover changed. Lengthening the payables turn was not sufficient to fund the increased accounts receivable and inventory. These working capital changes combined to result in a lengthening of the cash conversion cycle from 6 days to 25 days. For every $10,000 of daily sales, the company needed the line of credit to support an additional $190,000. The overall sales level stayed the same, but the operating cycle stretched and required significant additional capital.
Is a Borrowing Base Certificate (BBC) forecast necessary?
When the company and its investment banker analyzed the impact of the transactions, they assumed that replacing one aspect of the business with an expansion into a higher margin business would be a net positive. They assumed sales would remain the same and margin would increase. This view failed to consider how the accounts receivable and inventory would perform, and what impact the investment in receivables and inventory would have on cash.
In addition to incorrectly forecasting the levels of receivables and inventory, the financial forecast did not include a borrowing-base forecast. The forecast used the amount outstanding on the line of credit as the balancing item in the balance sheet forecast. The company and its investment banker compared the calculated line needed to the gross commitment and asked for an increase in the gross commitment, without estimating availability under the then existing Borrowing Base Certificate (BBC) formulation.
This analysis missed availability impacts from three sources. First, customer concentrations increased. Second, more government receivables were created. And, third, more aged receivables were created because certain customers consistently paid at more than 90 days. All these changes resulted in increased ineligibles.
How can a lender avoid this situation?
Weak forecasting by the company and a lack of understanding of cash flow and BBC forecasting by the investment banker combined to create an extremely difficult workout situation for the lender. The lender relied on the company and its investment banker to prepare a reasonable financial forecast, and used this forecast to prepare loan-committee approval documents.
The lesson to be learned is to require both a working capital forecast and a BBC forecast, when faced with any change in the borrower’s business model. In the example above, issues were related to the management of working capital assets and liabilities, as well as changes created in ineligibles. But, these are not the only areas that can be missed when forecasting a BBC.
Inventory: If there are changes in the sourcing of inventory, to include additional offshore sourcing, the inventory and related ineligibles could be materially impacted. Companies may need more inventory to handle the shipping time frames from an offshore source, and payments may need to be made to the offshore supplier before inventory becomes eligible collateral under a BBC formula. This impacts cash, accounts payable, and inventory. Also related to inventory, if a company chooses to focus on reducing inventory, the proportion of inventory in WIP may increase, as it is easier to reduce raw materials and finished goods. This could increase the relationship of ineligibles to total inventory.
Accounts Receivable: When considering receivables, the earlier example shows that consideration must be given to concentrations, government receivables and payment standards in the business. Additionally, there can be problems with changes in the supplier/customer mix which could result in additional offsets between accounts receivable and accounts payable. Consider a situation where one of the borrower’s vendors asks the client to do value-added work and sell the product back to the vendor. This would increase the cross-age ineligibles.
Reserves and Structural Changes: When businesses change, the potential to encounter additional reserves or other structural changes to the BBC are heightened. Consider a situation where the borrower increases credit card receivables, but those are financed through the same financial institution providing the line of credit. These additional credit card receivables would result in a higher reserve related to the credit card payment risk.
When considering the impact of a change in the borrower’s business, thinking through all aspects of the BBC calculation and the cash-flow forecasting is important. One approach that can provide significant analytical value is a sensitivity analysis. Consider the impact of the changes to the business one step at a time. Equating a $100,000 change in availability, ineligibles, etc. individually can help build a picture of potential outcomes, and the related risks. The ability to explain how a $100,000 change can impact financial performance will typically demystify the financial forecasting and BBC modeling.
In summary, a change to a borrower’s business can have a variety of unintended or unanticipated consequences even when, at first blush, the change in business seems positive. A financial forecast does not tell the whole story. Often, in forecasting models either cash, accounts payable or the line of credit are used as balancing accounts in the forecast balance sheet. Without expanding the analysis to include a BBC forecast, all parties are at risk of suffering from these unintended and unanticipated consequences.