TSL EXPRESS EXTRA
The Role Of Operations In Credit Risk Management
By Anne Mwangi
This article is one of two essays to win an Honorable Mention designation during the CFA Women in Commercial Finance Young Professional Thought Leadership Contest held last summer. Look for the second one in TSL Express soon!
Credit risk is the potential that expected or unexpected events will have adverse effects on a lender’s earnings, capital or franchise or enterprise value. Credit risk may arise from inadequate accounting and inventory control systems, poor collection practices or inaccurate collateral valuation, among other factors. It is imperative that management and operational professionals share the knowledge and experience to recognize, assess, mitigate and monitor the risks unique to asset-based lending (ABL). Success or failure in serving a customer efficiently while managing credit risk depends on understanding the role one plays in the company and also how well the teams work together. Here we will examine the role of operations professionals in successfully managing credit risk.
In his book, Asset Based Finance: Proven Disciplines for Prudent Lending, Gregory Udell, states that at its most fundamental, asset-based finance describes a financing philosophy where the amount of the loan is primarily based on the value of the customers’ collateral as opposed to financing that is primarily based on the firm and its creditworthiness.
Historically, asset-based financing provided credit to distressed firms in small and mid-size markets; however this financing philosophy, which includes ABL, factoring and floor-planning, has grown significantly. A survey conducted by R.S. Carmichael & Co., on behalf of Commercial Finance Association (CFA) highlighted that at the end of 2013, the ABL line credit commitments totaled $200 billion. This represented a 9% increase from 2012. Firms that are faced with a situation where growth outpaces capitalization are ideal candidates for asset-based financing. Asset-based financing also provides working capital for healthy companies interested in credit structures that are more flexible and have less restrictive financial covenants than traditional lending structures.
As the ABL industry grows in size and complexity, there is a growing need to successfully manage risk associated with the industry. From the article, An Ocean of “Cs”, featured in the book, Classics in Commercial Bank Lending, Jack Crigger poses the question: “At a time that the trend in most everything is back to basics, what could be more basic than discussing credit risk?”
In March 2014, the Office of the Comptroller of the Currency (OCC) issued a new handbook titled Asset-based Lending which provides guidance to federal bank examiners, national banks and federal savings associations on the safety and soundness of asset-based lending (ABL). OCC identifies credit risk, operational risk, compliance risk, strategic risk and reputation risk as the primary risks associated with ABL. Of these five risk factors, credit risk is considered the most significant risk associated with ABL because the typical ABL borrower may not be as financially sound as other commercial borrowers.
Typically, an ABL loan is structured as a revolving line of credit that seeks to maximize working capital availability based on the company’s asset base. The current status of the lender’s collateral is reported on a borrowing base certificate that is submitted by the borrower to the lender. The lender establishes parameters of the borrowing base, allowing the borrower to advance against a percentage of eligible receivables and inventory. As a result, asset-based finance emphasizes monitoring collateral, in the form of accounts receivables and inventory, throughout the lending relationship. To mitigate credit risks, a lender needs to view the process from a systems lens, which is based on the assumption that a system, in this case the ABL organization, is made up of various parts that are inherently interconnected as illustrated in the diagram below. The Operations team’s role in managing credit risk can only be understood in relation to other team players in the system.
Several team players are involved in the lending process at different stages. At the onset, the sales team works with the field examination, legal and underwriting teams to secure a loan transaction. The process involves conducting a due diligence review that seeks to identify problem areas to be resolved and the documents required to adequately reflect the transaction. After documentation, the relationship or account manager implements the terms of the loan. A central role of operations professionals is to make cash advances to a borrower to meet their current needs based on a thorough examination of the collateral standing as stated in the collateral loan reports and supporting documentation, all the while involving the accounts manager when the risk of lending rises beyond the acceptable level.
Loan Documentation and Agreements
Legal documentation begins once the business terms of a particular loan transaction have been negotiated between the lender and borrower. Asset-based loan documents include the Loan and Security agreement. This key document lays out the terms of the loan. The agreement breaks down definitions, spells out agreements to lend, describes the credit facilities, details pricing structures and conditions that must be met before lending can occur. The agreement also covers commitments from borrowers and deterrents set forth by the lender in the covenants section and what remedial action is to be taken in the event of default. A number of ancillary documents are also produced as necessary to cover aspects of the transaction that cannot be covered completely, or not covered at all in the Loan and Security agreement. These documents include promissory notes, guaranties, landlord’s agreements and subordination agreements.
Though operational professionals are not actively involved in the loan documentation process, the resultant is important in understanding each ABL facility. Beyond the legal jargon, the operations team should have an understanding of the loan documents as written. In defining the securities interests, the Loan and Security agreement should completely and accurately describe the eligible collateral. Therefore, operational professionals can compare what the reporting practice is to what is outlined in the loan agreement through an analysis of the borrowing base certificate and supporting documentation submitted by the borrower for advance requests. It is important to understand the purpose of each ancillary document, its scope and when it should be used.
Collateral is viewed as the primary source of repayment of an asset-based loan in the event that the borrower fails to service the loan through its cash flow or asset conversion cycle. This right to collateral is obtained when the lender takes a perfected, first position security interest in the assets of the borrower. In perfecting security interest, the lender asserts legal validation of rights to collateral against other creditors. Article 9 of the Uniform Commercial Code (UCC) recognizes a variety of methods of perfection, depending on the nature of the collateral. There are situations, however, where other creditors obtain automatic lien positions on a borrower’s assets through statutory law. These rights, known as secret liens, are usually not reflected in UCC searches conducted to unearth prior liens on personal property. Some of these secret liens to be aware of include landlord liens, warehouseman’s liens, grower’s liens as outlined in the Perishable Agricultural Commodities Act (PACA) of 1930 and maritime liens.
Collateral should be continuously checked as to its authenticity and value. The concept of ineligibles is central to collateral control and monitoring. Ineligible collateral describes pledged collateral that does not meet the criteria outlined in the loan agreement and therefore not included in the borrowing base. The primary category of ineligibles is delinquent accounts. The standard for delinquency is three times term. Significant past dues are an indication of credit weakness or some other problem with the account debtor. Other categories include credits in the past due that understate the true delinquency total, cross-age balances, inter-company and affiliate accounts, contras and foreign accounts. Borrowers with concentration debtor accounts represent a higher risk to a lender. These risks include credit risk, collateral risk and fraud risk. Any significant debtor concentration should be examined to determine credit strength, payment history, future activity and special sales terms. Given the emphasis that is placed on the quality of collateral in ABL, operational professionals should observe that the borrower is calculating and reporting ineligibles accurately.
Detailed receivables aging reports outline the status of the balances owed by respective customers listed, the invoice dates and numbers, debit and credit memos and payments made. A detailed aging allows analysts to track invoices as they age, conduct invoice verification and determine whether the borrower is complying with the borrowing base requirements in the loan agreement. While reviewing a receivables aging report, the analyst should also take note of relatively large invoices balances that fall in the critical period and bringing it to the attention of the account manager. This period occurs when invoices are about to fall into the past due category.
Asset-based lending is characterized by the reliance on funds provided by the conversion of working-capital assets to cash. A borrower’s operating cycle describes the steps the business takes to purchase goods or raw materials, convert those goods to inventory, sell the inventory, and collect the accounts receivables. The operating cycle is generally calculated as inventory days plus receivable days. Operating cycles vary from industry to industry depending on the length of the production process and credit terms offered. A company with a long operating cycle likely has a greater need for financing than one with a short operating cycle.
Through an analysis of the borrower’s operating cycle in days, an asset-based lender understands the borrower’s ability to convert working assets to cash over a meaningful period. This analysis can be compared to available industry data and the borrower’s historical performance. Measures used in the analyses include inventory turnover, accounts receivable turnover and accounts payable turnover. Inventory turnover measures how many times a business is able to turn inventory during the year and is expressed as a measurement of cost of sales divided by the average inventory. Higher turnover rates are desired because it indicates inventory conversion and a lower likelihood of inventory deterioration. Accounts receivables turnover measures the number of times receivables are converted to cash and is calculated as sales divided by average accounts receivables. Turnovers that are lower than historical or industry averages indicate certain red flags worthy of a close examination. Issues may include customer dissatisfaction, inefficient collection and unsatisfactory credit practices. Accounts payables turnover measures the number of times liabilities owed to suppliers are satisfied. The turnover is calculated as cost of goods sold divided by average accounts payable. Lower turnover rates may indicate cash flow restraints or funds redirection in cases where the company has a favorable performance.
When analyzing trends it is important to look at the flow of cash in the operating cycle, from when an advance purchases inventory to receivables collection. Trend cards are created to track each collateral component in the operating cycle over a certain period and to compare variations in each. For example, inventory trends should be compared to the changes in receivables. Keeping track of the cash in the operating cycle allows informed advances to be made because they are based on the current “health” of the cycle.
Lenders conduct regular field audits as part of the due diligence and ongoing monitoring process. Field examinations provide timely and accurate analyses of collateral assigned to the lender. Field examiners give a first-hand account on the state and performance of the collateral through an examination of the lender’s original books and records. Field examinations involve spending appreciable time with the management team, asking the right questions. Examiners evaluate the validity and adequacy of a borrower’s collateral reporting and controls. Red flags are more likely to be recognized while on site.
The scope of field examinations includes accounts receivables and payables, inventory, financial statements and tax status. Examiners conduct several tests to check on the authenticity of the receivables and if the dilution reserves are appropriate. Dilution is an important factor in determining an appropriate advance rate and gives an estimate of how much of the net accounts receivables can be expected to be uncollectible in the event of liquidation. Expressed as a percentage, dilution represents the difference between the gross amount of invoices and the cash actually collected from these invoices. These non-cash reductions include sales returns and discounts, volume rebates, invoicing errors and bad debt write-offs.
Audit reports identify risks, trends and deteriorating situations, if any, and recommend what type of appropriate action to take. In reviewing field audit reports, operations professionals should understand how the key conclusions were arrived at. Also, ineligibles and availability calculation comparisons should be made between the amounts indicated in the audit and those submitted on a borrowing base certificate as of a particular day, noting differences if they occur.
As the ABL industry continues to grow in volume, so does the complexity of collateral securitized and consequently increased importance in managing risk. There is insight that is drawn when a complex issue such as credit risk is examined through diverse lenses or perspectives. As a result, there is a growing need for cross-lateral training among ABL team players with an aim of having a thorough understanding of each ABL facility as well as continuous professional development training to keep abreast with developing industry trends.
Anne is a collateral analyst at Southeastern Commercial Finance in Birmingham Al. She holds a degree in Business Administration. She enjoys outdoor activities. Anne can be reached at email@example.com
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