importance of revolving credit facilities to the credit manager, The
For today’s credit manager, looking at a customer’s revolving credit facility is a crucial step in the evaluation process. However, credit agreements are legal documents that can run up to 400 pages, the majority of which have no significance to the credit professional. In order to recognize what information is important in a credit agreement, we should take a step back and look at the purpose and characteristics of a revolving credit facility.
What is the purpose?
The purpose of a revolving credit facility should be to finance a company’s working capital requirement throughout the operating cycle (the purchase of inventory, the repayment of payables, or the carrying of receivables). Unfortunately revolvers are often not used for their intended purpose. Often times they are used to purchase long-term assets or to make interest payments on other debt obligations. When this is the case, it represents a red flag to the credit manager, that should be recognized.
Characteristics of a Revolving Loan Agreement
All loans, including revolving credit facilities can be classified by three main characteristics. These are: a) Maturity b) Security c) Structure.
Revolving credit facilities can be short-term (less than one year until maturity) or long-term (more than one year). Most are long-term for periods of three to five years. However, even short-term one-year facilities usually have in place an automatic annual renewal process. It is important to remember that even though a revolver may not mature for three years out, individual draws upon the revolver are short-term in nature. These borrowings are typically for 30, 60, or 90 days. The total amounts outstanding under a revolver fluctuates on a daily basis as borrowings are repaid and new amounts are drawn down. In theory, if a Company draws down money under a revolver for a period of 30 days, that money will be repaid at the end of the time period. However, in reality what often occurs is the borrowing is rolled over after 30 days for another 30 day period. This situation can go on for the entire length of the facility, until the revolver reaches maturity. To protect themselves from this situation, many banks include in revolving credit agreements (especially those for retailers) language referred to as a “Clean Down Provision.” A Clean Down Provision requires the borrower to reduce total borrowings under its facility to below a certain level, or even zero, for what is usually a period of 30 consecutive days. For retailers this requirement usually comes sometime between December and March of the following year, to take advantage of the holiday season push. From a credit professional’s perspective, it is important to note any upcoming clean down provisions. If a company you are concerned about has $200 million outstanding under its revolver at November 15, and the clean down provision requires borrowing to be zero for 30 consecutive days between December 1 and March 1, keep an even closer eye on this customer.
Revolving credit facilities can either be secured or unsecured. Inventory and/or receivables usually back those that are secured. If borrowings under a revolving credit facility are secured, it is important to remember that the security is only as good as the value of the assets pledged. If the value of the assets decreases banks can become unsecured. For example, if a $100 million revolver is secured by inventory and receivables with a value of $120 million, then the banks are over-collateralized and there is no issue. However, if the value of the inventory and receivables decreases to $80 million for whatever reason, and the company has $90 million of borrowing outstanding under its revolver, then the banks are essentially unsecured for the $10 million difference. To protect themselves from this situation, revolving credit agreements will often include a formula driven borrowing base.
A borrowing base limits total borrowings to a percentage of certain assets, usually inventory and/or accounts receivable. This percentage is referred to as an advance rate. It is an estimate of the value of the assets that would be received in the event of a liquidation. The advance rate on accounts receivable is greater than that on inventory because accounts receivable are closer to being converted to cash than inventory. Furthermore, inventory has seasonal and obsolescence issues that may impact its liquidity value. Typical borrowing base language that might be included in a revolving credit agreement would be: Total borrowings are limited to 75% of eligible accounts receivable plus 64% of eligible inventory. The word “eligible” is a defined term that can be found in the credit agreement.
Recognition of a borrowing base is critical in determining what actual availability is under a revolver. The important thing to remember is that availability is not always what it seems, because of the presence of a borrowing base and letters of credit. While letters of credit are not direct borrowings and will not be found on a balance sheet, they do reduce availability and should be noted. Companies can often present information that is correct although misleading. If a company states that it has $10 million of borrowings outstanding under its $100 million revolver, the immediate assumption is that there is $90 million of additional availability. However, the company may not have mentioned the existence of a borrowing base or outstanding letters of credit. These two factors can significantly reduce what might otherwise be perceived as adequate availability under the revolver.
The structure of a revolving credit agreement pertains primarily to interest paid, fees, and covenants. Most revolvers have two interest rate options based upon Prime or LIBOR, plus an applicable margin. This margin is often tied to certain financial ratios that measure the company’s performance. Fees paid are essentially unimportant to the credit professional except to the extent that they are cash charges. Covenants, on the other hand, are perhaps the most critical component of a revolving credit agreement and will be discussed in detail shortly.
What are the Pitfalls?
To better understand the importance of revolving credit facilities, one must be able to identify what can go wrong with them. There are basically four main things that can go wrong and should trigger a red flag for you the credit professional:
Proceeds Used for the Wrong Purpose – An example of this is when a company draws down on its revolver to make a coupon payment on its Sr. Notes. There is never a good time to use borrowed funds to pay interest on previous borrowings.
Increased Accounts Receivable Losses l Slow Moving Inventory – It is the collection of accounts receivable and the sale of inventory that generates the necessary cash flow to repay revolver borrowings. If receivable losses or slow moving inventory occur over an extended period of time the credit professional should pay close attention.
Collateral Fraudulently Pledged – If a revolver is secured by certain assets and it turns out those assets don’t exist or are materially different than described you have a serious problem.
Poor Profitability/Cash How Loan Covenants
To protect themselves against the above problems, banks will include loan covenants in a revolving credit agreement. Loan covenants can be classified as either financial or non-financial. From a credit professional’s perspective non-financial or affirmative covenants are fairly boilerplate, and generally somewhat obvious requirements. These include requirements to maintain insurance, pay taxes, comply with laws, etc.
Financial covenants, also known as negative covenants, provide banks with some control over the actions of a company and prevent the dissipation of financial resources and assets. Financial covenants should address several areas of a company’s operations. Although no credit agreement will address all of the topics listed below, some combination of them should be included. Listed below are the topics as well as examples of the financial covenants that would address them:
* Cash Flow – minimum EBITDA and interest coverage
* Profitability – same as above
* Efficiency – minimum inventory turnover
* Liquidity – cash, current, and quick ratios
* Solvency – limitation on the payment of dividends
* Capital structure – maximum leverage ratios
Asset quality – limitations on the sale of assets
In addition to the aforementioned, financial covenants will often place restrictions on:
a) the assumption of additional debt
b) the incurrence of liens
c) capital expenditures.
Calculating a company’s performance against financial covenants can be a difficult, sometimes impossible process given the information that is publicly available since there are often adjustment set forth in the defined terms which may vary significantly from text book definitions. The best way to assure accurate monitoring of the company’s performance is to obtain the information directly from the company, if they are inclined to do so. Comparing performance to covenants on a trend basis will provide the credit professional additional insight into the company’s overall financial picture.
Non-Compliance with Loan Covenants
If a company is not in compliance with a covenant, they are in default, which is obviously a huge red flag to the credit manager. When a company is in default, the banks are left with basically three options:
* The banks can waive the event of default on a one-time basis. For this, the banks often receive a waiver fee or will increase pricing on the facility.
* The banks can amend the covenants in question going forward. An amendment will include a waiver of the covenant default and will “relax” the covenant going forward based upon agreed expectations of the company’s performance. As with a waiver, the banks will often receive a fee and/or will increase pricing when a covenant is amended. Companies that are forced to frequently amend their revolving credit agreement for covenant defaults represent a significant risk to the credit manager.
The banks can pursue collection by accelerating the maturity or “calling the loan “. This is a last resort for the banks indicating a lack of confidence going forward that the company can perform or that collateral coverage is in questions. In either case, this action will often result in a bankruptcy filing by the company.
Monitoring a company’s revolving credit facility can be a valuable tool for today’s credit manager. The importance of a borrowing base as it relates to credit availability, and performance against financial covenants are the two main components of a revolver that bear watching. Some of this information may be more difficult to obtain than others, but in any case the best source is always the company itself.
This article was taken as a component of the Credit Executive Study Program (CESP) conducted by F&D Reports. Other topics covered in the CESP include Cash Flow Analysis, Liquidation and Valuation Tools, Industry Overviews, Merger & Acquisition Analysis and others. If you are interested in learning more about F&D Reports or the CESP, please contact Tony Lobosco at (800) 789-0123, Ext. 113.
Scott Friedman is cm Assistant Vice President for F&D Reports.
Copyright Credit Research Foundation Third Quarter 1999
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