Borrowing Base: How it Works

An asset based working capital line of credit— or revolver— provided by a lender typically incorporates a provision called a “borrowing base”. A borrowing base is a calculated dollar value that sets the upper limit on how much money the company can borrow from its lender on the line of credit. This borrowed working capital is used to fund ongoing business operations, such as purchasing inventory needed for later sales, or to finance accounts receivable. Understanding how a borrowing base works is important for understanding how high your working capital line of credit could be. We also discuss how a working line of credit may be used in acquisitions.

What is a Borrowing Base?

A borrowing base, in simple terms, defines how much money an asset based lender is willing to loan a company. The borrowing base is calculated based on the value of the company’s assets used as collateral. However, determining the collateral value of those assets is not as simple as taking the book value. A portion of the assets may be excluded, and the lender also applies a discount factor, known as an advance rate. We will detail how to calculate a borrowing base in this post.

Collateral Types

Different types of assets can be used as collateral, such as accounts receivable, inventory, or equipment. Larger assets such as property are typically not used as collateral for a working capital line of credit. Such assets are more fitting for long term debt, like a house in a mortgage for example. In general, assets that hold value over an extended period of time— and decline in value predictably— are paired with long term debt, while assets with temporary value are paired with short term debt.

Borrowing Base Calculation

The borrowing base calculation begins with the book value of accounts receivable and inventory. Next, certain ineligible assets (as defined in the credit agreement) are removed. Finally, the value of remaining eligible assets is then multiplied by the advance rate, or the portion of the assets the lender is willing to lend against. The advance rate for accounts receivable is typically 80%, and the advance rate for inventory is usually 50%. Then these two separate values are added together to determine the borrowing base amount.

For example, if a company’s eligible accounts receivable balance is $1.6 million, then calculating the accounts receivable portion of the borrowing base looks like this:

1,600,000 x .8= 1,280,000

And if the value of the company’s eligible inventory is $1.0 million, then calculating that portion of the borrowing base looks like this:

1,000,000 x .5= 500,000

To calculate the final borrowing base value, both portions are added together:

1,280,000 + 500,000 = 1,780,000

In this situation, the company’s borrowing base would be $1,780,000. The question then becomes, what assets are ineligible?

Ineligible Accounts

Unless deemed ineligible, the borrowing base calculation includes all inventory and accounts receivable. Generally, ineligible accounts are ones the lender views as risks on the ability of the borrower to convert to cash.

Old Accounts Receivable

When a company sells with credit, it is normal for invoices to take some time to get paid. While due in 30 days is common, some accounts receivable can creep into the 60-90 day range. When an account ages past 90 days, it can signal distress on the customer and indicate uncertainty that the customer will pay the balance. 

While it depends on the lender’s risk tolerance, most lenders will remove the entire account associated with the late payment. So if a customer has not paid a balance in 90 days, the full account associated with that customer would be removed from the borrowing base.

Customer Concentration

The more diverse group of buyers a company has, the less harmful it will be if one customer stops doing business with the company. As soon as a sizable amount of business is concentrated to one or a select few customers, the lender will be wary. This is because if a large customer fails to pay, the company’s accounts receivable balance will drop significantly, and the lender may have advanced funds based on this collateral. Now the lender will be in an over-advanced position and might require the borrower to immediately reduce the outstanding balance on the line of credit to bring it back in compliance with the borrowing base.

To reduce exposure to this risk, banks will often set a customer concentration limit, say at 25%. If a customer makes up 40% of the company’s accounts receivable, for example, 15% of the balance would be removed from the borrowing base.

Unsellable Inventory

As inventory value makes up some of the borrowing base, the ability for the inventory to be sold must be monitored. Sometimes inventory proves to be obsolete, excessive, or otherwise unsellable, while the company could still be including this inventory’s value on its balance sheet. For the inventory balance to be accurate, the company would need to remove the value of the unsellable inventory. 

To mitigate this risk, the lender may conduct site visits— to the company’s warehouse for example. This is to ensure undesirable inventory is not piling up somewhere. In addition to site visits, lenders will watch for trends in inventory sales. For example, if inventory’s time in the warehouse is typically short-lived but becomes much longer, the lender may start asking questions. 

One strategy to protect against future obsolescence is the use of inventory caps. Inventory caps are based on past sale trends: if a company typically only sells a certain portion of its inventory while the rest ages out, the value of the aged out portion would not be included in the borrowing base. The inventory cap is an estimate based on projected future performance. For example, the bank may exclude inventory that is in excess of one year sales.  As a result, the portion of included inventory could be very different from the company’s inventory book value.

Government Accounts

Any balances associated with the Federal government are typically not included in the borrowing base. This is because the company cannot sue the government for any outstanding balances.

Borrowing Base Certificate

Over time, a company’s borrowing base must be monitored. A borrowing base certificate is a formal document that governs how the borrowing base will be re-calculated over time. In other words, it sets the terms for the loan and the amount that can be advanced. Because a company’s inventory and accounts receivable fluctuate often, the borrowing base may need to be calculated often. 

For the lender to monitor the borrowing base, the borrower is required to supply an accounts receivable and inventory record at regular intervals. Such monitoring ensures the lender is only advancing what can be backed by its assets.

Borrowing Base and Acquisitions

Can a working capital line of credit be used to finance an acquisition? A line of credit is typically not an appropriate financing source for acquisitions. As discussed earlier in this post, larger assets with predictable long-term value are better suited as collateral for longer term loans. Thus, term debt should make up a large portion of an acquisition, for example 50%. If a working capital line of credit is used to finance an acquisition, it is typically a very small portion— like five to ten percent of the total sources of funds.

1719 and Acquisitions

When 1719 Partners completes an acquisition, we always have a working capital line of credit to ensure business operations can continue as usual. We recognize that this is necessary to fund a business’s liquidity needs. As mentioned above, 1719 does not rely on a line of credit to finance an acquisition; most of the financing is supplied by term debt and our equity investment. 

If you have any questions on how a borrowing base works, or about using a working line of credit in acquisitions, we would be happy to help. Simply contact us and we will be in touch.