This article originally appeared in ABFJournal
As the COVID-19 pandemic ramps back up through the end of 2020 and the beginning of 2021, a tentative ‘new normal’ has set in for borrowers and lenders alike. Juanita Schwartzkopf explains how asset-based lenders should adjust their evaluation processes for working capital in this environment.
With 2020 nearly behind us, our attention can be directed to the future and how to deal with the long-term impacts of the ongoing COVID-19 pandemic on the U.S. economy. While the “new normal” has not been completely sorted out, asset-based lenders will be able to creatively use their existing tools to reduce risk going into 2021.
For example, the approach to analyzing working capital today needs to be focused on facts and real-time information, not on assumptions and excuses. As with any key event in our lifetimes, such as 9/11, the tech bubble or the real estate bubble, businesses will use the event as an excuse for poor performance and allow lenders to assume all performance issues are tied back to COVID-19 impacts.
Accounts Receivable
In evaluating accounts receivable, look at aging trends over time. If monthly information is available, use it. If monthly information has not been provided, require it. It is not unusual for a business to have experienced a slowdown in receivable collections during April and May, but effective working capital management would have reversed that trend by now.
Accounts receivable also must be analyzed for concentrations. It will be important to consider changes in customer concentrations to evaluate the need for additional or revised concentration limits. Customer bases may have changed, and concentration limits may need adjusting as well.
Evaluate aging categories by customer to determine if cross aging standards are appropriate. With the new aging trends and customer receivable balance concentrations, consider the need for cross aging calculation adjustments.
Figure 1 shows an example of accounts receivable balances from January to October of 2020 for a company that experienced an immediate reduction in receivables, then an increase in receivables, along with a delayed increase in past due balances.
In addition to changing total levels of accounts receivable, the relationship between total receivables and receivables more than 30 days past due is of concern. This warrants further review of customer concentrations, cross age requirements, and current credit and collection policies.
Inventory
When evaluating inventory, using a 12-month period for breakdowns by key category over time is also critical. Raw materials, work in process and finished goods relationships may have changed. Tying overall advances to relationships between the key categories should be adjusted for new work processes, new workflows and changing customer relationships.
Most computer systems businesses use today provide an inventory aging report. If an inventory aging is not a current requirement, consider adding it to the monthly or weekly reporting package that a borrower is required to submit. If the borrower submits inventory agings currently or can provide one as of year end, evaluate the aging as you consider liquidation values and advance rates for inventory. Also consider adding an aged inventory ineligible calculation to the borrowing base structure.
Review inventory turnover by SKU on at least a quarterly basis. Overall inventory turnover may have been stable, but the slower moving inventory may have increased as a percent of total inventory. Appraised values may have been established using pre-COVID-19 SKU turnover information, and advance rates tied to appraised values may need adjusting.
If the borrower provides customer purchase order, inventory and/or vendor purchase order relationships, lenders would be better able to assess the potential value of the inventory during a liquidation. Typically, a lender sees inventory turnover ratios by SKU; however, it would be even more beneficial to tie SKUs through the entire process. Expanding the scope of planned field exams to incorporate this analysis, or specifically requesting this information from appraisers, could enhance the decision-making around inventory advance rates and conversion to cash time periods.
If advance rates are tied to appraised inventory values, a review of at least 18 months of inventory appraised valuation information should be developed. During the March to June period of 2020, appraisal values were negatively impacted by COVID-19 uncertainties. After July, different appraisers took different approaches to inventory appraised values and uncertainty. As a result, asset-based lenders need to look at appraised values over time and understand how the appraiser considered 1) the relationship between key inventory categories, 2) inventory turnover, 3) the costs to complete work in process and 4) the costs to liquidate. Small changes in assumptions could have major impacts on values and availability.
Figure 2 shows the inventory aging for the same company from Figure 1. After initial decreases in inventory levels, inventory increased, with the amount of current inventory showing the largest increases.
The make-up of the inventory and the SKU sell through rates, along with the inventory turnover ratios compared to sales, warrant further review.
Relationship Between Accounts Receivable and Inventory
With both accounts receivable and inventory changing, a borrower’s working capital management strengths and weaknesses are more obvious. A borrower with strong working capital management in one category but not in another could put a lender at more risk during a liquidation. Understanding each individual asset category — and the interrelationship between the categories — could put the lender in a stronger position if that information is used to adjust the line of credit structure.
In Figure 3, the relationship between accounts receivable and inventory for the company from the previous figures shows a growing reliance on accounts receivable compared with inventory.
The required relationships between accounts receivable and inventory, and any caps on percentages, should be evaluated. The cap on the line of credit and the operating cycle also warrant additional discussion and review.
New Normal
The receipt of 2020 performance information allows a lender to consider each borrower’s new normal. A lender should look at this time as an opportunity to underwrite a new line of credit or loan relationship. Because of the Q1 timing of COVID-19, borrowers should be able to provide three quarters, or nine months, of post initial COVID-19 impacts. The last few quarters of financial performance should be indicative of the new normal for most businesses.
With this information in hand, consider the revised operating cycle of the business. Calculate the operating cycle as of each month for the past year and evaluate whether the company has been asked to be a bank to its customers or its suppliers. Looking at the operating cycle will enable you to evaluate that aspect of cash use and discuss the operating cycle with the borrower.
Looking to the Future
2021 will continue to be challenging for lenders and borrowers. Reviewing accounts receivable and inventory information in conjunction with financial performance will help lenders restructure working capital lending. If lenders also evaluate accounts payable and accrued expenses, line of credit structures could be further enhanced. For example, if a business deferred the employer portion of payroll taxes, an ABL lender may want to determine the amount of that deferred liability and establish a reserve for the Dec. 31, 2021 and Dec. 31, 2022 payments. Lenders have elected to do everything from fully reserving the amount due in 2021 and 2022, to each year reserving a 12th of the annual payment as a monthly reserve building to the full annual amount due on Dec. 31, 2021 or 2022.
Use this opportunity to underwrite borrowers as new clients, gather detailed monthly information on all aspects of working capital, anticipate the operating cycle moving through 2021 and make sure the line of credit structure works for both parties.
