Intial Credit Decision

Commercial lenders often receive requests to business accounts receivable, whether through a secured loan or a purchase. Growing companies need and want help in alleviating the cash flow stress caused by carrying this critical asset. This article focuses on the types of receivables facilities offered by banks; however, regardless of the funding source, a sound credit decision depends on the viability of the receivables as a repayment source and the ability to mitigate the risk.

Accounts receivable can represent a very sound repayment source because they will typically convert to cash faster than any other asset on the balance sheet. For the same reason, however, accounts receivable also can represent additional risks. While virtually all lenders know the five C's of credit, far fewer are familiar with the five keys to relying on accounts receivable as a repayment source:

* Making a prudent initial credit decision.

* Maintaining accurate and timely information.

* Ensuring control of the cash.

* Establishing effective monitoring procedures.

* Protecting against changing credit circumstances.

Prudent Initial Credit Decision The five Cs of credit - character, capacity, conditions, capital, and collateral - play a vital role in any prudent initial credit decision. Whether the proposed structure of the receivables relationship is a blanket-lien line of credit, a borrowing base revolver, or a purchase of the receivables, it is impossible to underwrite the proposed relationship effectively without giving consideration to these factors.

However, lenders relying on receivables for repayment must implement additional structure beyond observing the five C's. Unlike fixed assets, such as equipment and real property, accounts receivable represent a moving target. The lender must have proper information and ongoing control to ensure that the receivables are current and valid obligations and that the remittances from account debtors will, in fact, flow to the funding source for repayment.

Accurate and Timely Information A lender operates from a weak position unless he or she knows who the account debtors are, how to locate them, how much they owe, what was purchased, and the terms of sale. Accurate and timely information is critical to ensure repayment if circumstances require liquidation of the receivables. A detailed aging report prepared by the business provides some, but usually not all, of this information. Reports prepared by the business for submission to the lender may become suspect if the business begins to experience financial difficulty. Moreover, aging reports prepared by the business typically are not received by the bank until 15 to 45 days after the aging cutoff date, after many of the better, faster paying receivables have already been paid.

When operating from stale information (and especially if the bank is ignoring key number three), a lender makes the potentially dangerous assumption that the business has been able to generate new receivables to replace those repaid since the aging cutoff date. In failing to recognize the risk in this assumption, the lender gains a false sense of security and control when requiring periodic aging reports from a business with a traditional blanket-lien line of credit.

This false sense of security may extend to the bank's credit administration function, if credit administration assumes not only that the lender is receiving detailed information in a timely manner but also that the aging information is being analyzed and acted on if signs of trouble are spotted. In reality, many credit files are littered with aging reports that have been received and sent to the file more in an effort to clear a documentation exception than to analyze and act on the information.

Account Receivables