Collateral Analysis
Collateral: an asset that a lender accepts as security for a loan.
The collateral acts as a form of protection for the lender. That is, if the borrower defaults on their loan payments, the lender can seize the collateral and sell it to recoup some or all of its losses.
Collateral deficiency: Lack of collateral to support loan amount. Loan amount > collateral values of company.
Excess collateral: Excess collateral to support loan amount. Loan amount < collateral values of company.
Collateral Analysis: the analysis of the ability of collateral to support a loan. This analysis is critical to any lender because in a downside scenario such as bankruptcy, a lender wants to ensure that there is an alternate source of repayment, typically our primary source of repayment would be cash.
Examples of collateral a lender will analyze and use as security includes: Accounts Receivable, Inventory, Property Plant & Equipment and Real-Estate, etc.
Once we complete a Collateral Analysis, a lender will determine if a borrowing base will be required in the deal structure.
Borrowing Base: amount of money that a lender is willing to loan a company, based on the value of the collateral the company pledges.
typically determined by margining collateral at an advance rate. Once the advance rate is applied, the total value is the maximum amount a company can borrow at that point in time. Lenders feel more comfortable making loans rooted in a borrowing base since loans are made against specific sets of assets.
Characteristics that typically warrant the need to be monitored under a borrowing base include a company that is: asset heavy, has intensive working capital needs, is underperforming and/or does not have other collateral that can be used as security.
Advance Rate: The percentage of the value of collateral that a lender uses to determine the amount of a loan.
For example, if one pledges a collateral worth $10,000, and the advance rate is 90%, the lender will only extend $9000 in credit.
Because of uncertainty and risk, Borrowing Base formulas calculate the value of collateral using Advance Rates rather than the full value of the assets. This helps mitigate the fact that the value of collateral provided on the balance sheet may not be 100% accurate or may be valued different in a downside scenario.
Risks and Mitigants
1. Cash Flow Leverage (Total Funded Debt/EBITDA): ensures the company is generating enough cash flow in a specific period to cover its debt obligations.
the most common covenant requirement in the market and is used in the majority of transactions.
2. Net Cash Flow Leverage (Total Funded Debt less Cash / EBITDA): Similar to above, the difference here lies in the deduction of cash. This covenant is typically used when a client has historically maintained a sufficient amount of cash on their balance sheet.
This gives the company cushion: the more cash they have, the lower their leverage ratio giving them the availability to borrow more. Typically, a cash floor and cap are included in the calculation.
Cash Cap: Maximum amount of cash that can be applied to any scenario that involves using a cash metric.
Cash Floor: Minimum amount of cash that can be applied to any scenario that involves using a cash metric.
3. Tangible Net Worth (Total Liabilities/Tangible Net Worth): Used to assess a company’s actual net worth while excluding any assumptions of intangible assets.
This covenant is used to help lenders determine the size and terms of the borrowing facility so that they do not lend more than the company’s assets are worth.
This covenant would be used for a company who is asset heavy and would not be beneficial for a software company whose assets are primarily intangible.
4. Fixed Charge Coverage (EBITDA - CapEx / total fixed charges): Assesses the ability of a company to pay off outstanding fixed charges including interest, taxes, debt obligations, lease expenses, etc. This ratio is beneficial when a company has term debt and/or other required payments.
A ratio less than 1.0x represents deficiency in ability to meet fixed charges
a ratio greater than 1.0x represents ability to meet fixed charges.
5. Interest Coverage (EBITDA/Interest): Assesses if operating earnings can cover interest payments. An interest coverage covenant would be most beneficial for a company that does not have significant fixed charges.
An example would be a borrower who only has a revolving line of credit facility which requires interest only payments until maturity.
Revolving Line of Credit: a situation where credit replenishes up to the agreed upon threshold, known as the credit limit, as the customer pays off debt.
Facility: a formal financial assistance program offered by a lending institution to help a company that requires operating capital. Types of facilities include overdraft services, deferred payment plans, lines of credit, revolving credit, term loans, letters of credit, and swingline loans. A facility is essentially another name for a loan taken out by a company.
6. Minimum Liquidity (Permitted at any time for its total of cash and marketable securities to be less than a $ amount): Ensures the company maintains a specific liquidity position. Important for a company who may have significant cash burn and are historically tight on cash and or/marketable securities.
Cash Burn: The burn rate is usually quoted in terms of cash spent per month. For example, if a company is said to have a burn rate of $1 million, it would mean that the company is spending $1 million per month.
EBITDA (earnings before interest, taxes, depreciation, and amortization): a measure of a company's overall financial performance and is used as an alternative to simple earnings or net income in some circumstances.
EBITDA, however, can be misleading because it strips out the cost of capital investments like property, plant, and equipment.
EBITDA Cushion: In setting covenants, the amount of cushion against projected results is generally established through negotiation between a borrower and its lenders. Borrowers typically want more leeway against their expected results to reduce the risk of another default, while lenders typically seek tighter covenants in order to keep a closer eye on their troubled borrowers. EBITDA covenants are often set at levels between 75 and 95 percent of ""plan,"" and other covenants, if used, are keyed off the chosen level.
Covenant: In legal and financial terminology, a covenant is a promise in an indenture, or any other formal debt agreement, that certain activities will or will not be carried out or that certain thresholds will be met.
Covenants in finance most often relate to terms in a financial contract, such as a loan document or bond issue stating the limits at which the borrower can further lend.
Basis points (BPS or "bips"): a unit of measure used in finance to describe the percentage change in the value of financial instruments or the rate change in an index or other benchmark.
Think of basis points as a percentage - 100 basis points is equal to 1.00%. Therefore, the term sheet shows an undrawn fee of 50 bps which would be equal to 0.50%.
Undrawn Fee: A common fee a lender includes in a transaction. This fee will be applied to any amount of the loan that is not being used by the company. Therefore, the company will be charged a 0.50% fee monthly based on the $ amount that is not being used. For this example, the company currently has $126 million outstanding, thus, the company will be charged 0.50% off of the $74 million that is not being used.
Capital: a term for financial assets, such as funds held in deposit accounts and/or funds obtained from special financing sources. Capital can also be associated with capital assets of a company that requires significant amounts of capital to finance or expand.
Capital Expenditure (CapEx): funds used by a company to acquire, upgrade, and maintain physical assets such as property, buildings, an industrial plant, technology, or equipment.
DIO (Days Inventory Outstanding): how many days it takes to sell the entire inventory. The smaller this number is, the better.
DSO (Days Sales Outstanding): the number of days needed to collect on sales and involves AR. While cash-only sales have a DSO of zero, people do use credit extended by the company, so this number will be positive. Again, a smaller number is better.
DPO (Days Payable Outstanding): This involves the company's payment of its own bills or AP. If this can be maximized, the company holds onto cash longer, maximizing its investment potential; therefore, a longer DPO is better.
Free Cash Flow (FCF): the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.
Funded Debt: a company's debt that matures in more than one year or one business cycle. This type of debt is classified as such because it is funded by interest payments made by the borrowing firm over the term of the loan.
Litigation: The act, process, or practice of settling a dispute in a court of law.
Marketable Securities: investments that can easily be bought, sold, or traded on public exchanges. The high liquidity of marketable securities makes them very popular among individual and institutional investors. These types of investments can be debt securities or equity securities.
Net Working Capital (NWC): the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable. Net operating working capital is a measure of a company's liquidity and refers to the difference between operating current assets and operating current liabilities.
Tenor: How long the company has access to the capital.
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