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Is Your Borrower’s EBITDA Accurate?

October 22, 2014, 07:00 AM

ABL lenders place much of their focus on the valuation of the loan collateral, typically accounts receivable and inventory, when performing due diligence credit analysis. This collateral forms the basis for the borrowing base, and the conversion of such collateral is part of the lender’s exit strategy. Obviously converting the collateral to cash is the primary exit strategy; however, savvy lenders are also always concerned with repayment/paydown of the line of credit. Lenders therefore underwrite to EBITDA and spend significant time understanding the financial statements and management pro forma financials.

Large capital market non-ABL lenders devote considerable time and resources to independently evaluating EBITDA, above and beyond what is simply contained in historic audited financial statements, at a cost much higher than most ABL transactions will support. And as is often the case many ABL borrowers do not have audited financial statements and are reluctant to obtain them due to the cost and time strain necessary.

Lenders hire field examiners to go out in the field to validate collateral and collateral reporting, but while these field exams typically do a good job of AR and inventory collateral valuation, the standard ABL industry field exam scope and examiner does little to verify the accuracy of reported financial statements. So, what can your field examiners do ensure that the financial statements are accurate?

For many of our lenders, we have found that our “Earnings Validation Report” is a reliable and cost effective way of validating revenue and earnings, providing EBITDA analysis, delivering many of the insights of a Quality of Earnings Report, at a fraction of the cost. This analysis is performed with the goal of validating revenue and expenses, and hence validating EBITDA. The following steps are taken on each of our Earnings Validation Reports:

     1.  The examiner should have an in-depth conversation with the borrower’s accounting staff regarding the recognition and timing of revenue. How are customers obtained, how do they place orders, how the orders are fulfilled, when and how is revenue recognized? Does the company have deferred revenue? Is so, describe how revenue is recognized, when it is earned and how deferred revenue is tracked? The goal here is to make sure that all revenue recognized is truly earned.

     2.  The Revenue Validation is performed by reconciling revenue per the income statement to cash deposited into the bank statements, after adjusting for certain items such as changes in AR, deferred revenue, bad debt and other “non-revenue” deposits (such as intercompany transfers, insurance reimbursement, loan proceed or equity infusions).

     3.  The Expense Validation is performed by reconciling expenses per the income statement to cash disbursements out of the bank statements, after adjusting for certain items such as changes in AP & accruals, loan repayments, the employee portion of payroll taxes, cash fixed assets, depreciation, bad debt and other non-expense payments.

     4.  A sample test should be performed from invoices posted to the sales journal. Whereas the invoice/ship test is selected from the AR aging, this test is selected from the sales journal. The Examiner should obtain and vouch the following information:

Chart detailing items an examiner should obtain from sales journal - Blog on ABL Advisor - Is Your Borrowers EBITDA Accurate

     5.  A reconciliation should be performed between the revenue recorded on the income statement and the revenue per the examiner completed rollforward. Any variances should be explained.

     6.  The examiner should perform an in-depth analysis of the levels and reasonableness of bad debt and allowance for doubtful accounts. Also, if the borrower has inventory, the examiner should inquire as to how the cost of goods sold is determined. In both bad debts and cost of goods sold, there are some judgments that the borrowers are required to make and that can affect earnings.

     7.  Review and analysis of the financial statements and discussion with the Company regarding the possibility of any unrecorded transactions or material adjustments.

The above steps are not the totality of the Earnings Validation Examination, however, hits the high points.

On a recent exam, our firm discovered a material $1.6 million (19%) overstatement of revenue during performance of an Earnings Validation Examination of a Borrower, something that the lender was unaware of even though financial statements had been provided to the loan officer by the borrower.

The borrower had acquired Company A and was in the process of acquiring Company B. The proceeds of the financing were to be used to finance the two acquisitions.

Watermark used our standard scope for the Earnings Validation of the borrower. For Company A, in conjunction with the analysis of deferred revenue, an in-depth analysis of contracts was performed. An overstatement of revenue was discovered, as the deferred revenue schedule did not agree to the contract detail. For Company B, the analysis indicated that the Company did not have the level of cash receipts that supported the revenue reported on the Income Statement as identified by the Revenue Validation.

Ultimately, the lender declined the credit and may have saved themselves from a future loan loss or at the very least, saved themselves from a couple headaches and forbearance agreements. Likewise, the borrower realized that their analysis of Target Company B was faulty and did not consummate that particular acquisition and has used Watermark’s report to trigger the claw-back provisions in the M&A agreement with Company A. Even though the borrower was not our customer, it has subsequently engaged Watermark to perform Earnings Validations examination on their future acquisitions.

Scot Sandel
Managing Director | Watermark Advisory Group, LLC
Scot Sandel is a 16 year veteran of the commercial finance industry and Managing Director of Watermark Advisory Group, LLC, which performs credit risk functions on an outsource basis to commercial lenders and banks including underwriting, portfolio management, and field exam on asset-based, cash-flow and real estate transactions. Watermark's national team has experience in healthcare, manufacturing, service and a variety of industries and have performed exams ranging from $5MM to $100MM+. Sandel is responsible for managing multiple engagements, new business development and recruitment of examiners.

Previously, Sandel was Senior Vice President at Healthcare Finance Group and was responsible for developing and managing the national healthcare real estate lending platform. There, he developed the marketing strategy and managed all aspects of the risk profile including establishing lending procedures and credit guidelines. Prior to his tenure at Healthcare Finance Group, Sandel was with CIT Healthcare, a division of CIT Group, Inc, and was a founding member of the group and a major contributor in developing the real estate lending platform infrastructure, as well as assisting in the development of their asset-based product.

After several successful years as part of GE Healthcare Financial Services’ healthcare due diligence group, Sandel was selected into a management training rotational program in which he held underwriting, portfolio management and workout positions.

Watermark provides comprehensive credit and portfolio management services, including the performance of Field Exams, Revenue and Earnings Validations, Loan Underwriting and Portfolio Management Support. Watermark prides itself in providing accurate, thoughtful field exams across the entire US; making meaningful recommendations regarding the accuracy of the borrower’s reporting, their financial condition, collateral valuation and the credit structure.

Watermark’s Management Team has held key credit and audit positions for several large commercial finance lenders and has served in a variety of capacities including underwriting, workout, portfolio management and field exam over the past 15 years. To learn more, visit
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