By Gary Babbitt
The Daily Record Newswire
Although there is no comprehensive industry-wide data available to show what percentage of commercial loans made in the United States are backed by collateral, an educated guess would be that the majority of business loans made by community banks are backed by some form of security or collateral.
Business owners may find it helpful to understand why banks require collateral and how they place values on the assets that a business can offer as collateral because most commercial loans involve some form of collateralization. In my experience, bankers have always viewed collateral as only one factor, albeit a very important one, in their overall analysis of a commercial loan request.
Most bankers focus first on the cash flow of a prospective borrower and consider adequate historical or projected cash flow to be the most important factor when evaluating a loan request. Since bankers typically seek borrowing relationships where there is a “secondary source of repayment,” collateral and/or guarantees of the owners of the business are often required as part of the loan approval.
Secured lending can take many forms and it is important to point out that, while a lender may require the pledge of collateral for a loan or loans, some lenders may be willing to accept a collateral position that is less than the full amount of credit extended. Businesses with established histories of positive cash flow combined with low debt to equity positions and high levels of net worth may be able to obtain financing with less collateral than would be required from a newly established business or a business with a higher risk profile.
Bankers differentiate between the collateral value provided by traditional business assets and the value of the intangible assets or the “enterprise value” of the business.
Tangible assets include accounts receivable, inventory, equipment, furniture and fixtures and bank loans are typically secured by either a blanket lien on all of these assets or a specific lien on certain assets of the business. Real estate, vehicles or marketable securities are also frequently used to secure bank borrowings, though not included in the traditional definition of business assets.
Personal assets of the business owners are also used in some cases to provide additional support. The relationship between the enterprise value of a business and the collateral value of the assets of the business is an important concept.
The enterprise value of a business represents the value of the business if it were to be sold as a going concern. This value is often expressed as a multiple of cash flow, a multiple of a certain annual revenue stream (such as annual premiums collected by an insurance agency) or simply as the price that a third party may be willing to pay for the business.
The enterprise value of a business is often greater than the collateral value of the tangible assets of the business and bankers may not be willing to extend credit based solely on the enterprise value of a business — especially if there is a significant difference between the enterprise value and the bank’s estimate of the value of the underlying tangible assets of the business.
Subordinated loans provided by former owners, non-bank lenders or investors are often used to bridge the gap between the enterprise value or selling price of a business and the amount of financing provided by a bank. Some banks also utilize loan programs or guarantees available through local economic development agencies, government agencies or development companies to provide loans with higher loan to value ratios or more flexible payment terms than may be available under traditional lending parameters.
Since bankers want to understand what the assets pledged by a borrower might be worth at some point in the future, historical data is used to forecast what different types of assets may be worth if those assets were to be liquidated (either by the borrower or the lender) and used to repay loans incurred by the borrower. Most banks use current financial statements as the basis for their evaluation of business assets.
However, adjustments (both positive and negative) often need to be made to arrive at realistic collateral values for these assets. Ranges of value for business assets most often used as collateral are:
• Accounts receivable are valued at 65 to 75 percent of the balance shown on financial statements or accounts receivable aging. Lenders typically exclude foreign accounts and accounts after 90 to 120 days from invoice when valuing accounts receivable and higher discount percentages may apply if the business exhibits a history of significant bad debt expense or large sales concentrations with one customer.
• Inventory can show a wide range of value. Retail inventory or finished goods that can be readily sold to third parties may be valued at up to 40 to 50 percent of the balance shown on recent financial statements; conversely inventory consisting of work-in-process or obsolete goods would likely have little or no value to a lender in a liquidation scenario.
• Equipment, furniture, fixtures and vehicles also show a wide range of values and are difficult to evaluate using only financial statements since the depreciation schedules used in financial statements or tax returns may differ from the useful life of the asset. Because the age, condition and obsolescence of these assets are critical components of their value, physical inspections combined with the use of appraisals or third party valuation guides are often the best way to arrive at realistic collateral values for these items.
• Real estate, whether used to secure a conventional mortgage loan or used as supplemental collateral for another type of loan, is usually valued at 70 to 80 percent of its current market value. It is important to note that there are several programs available, including the U. S. Small Business Administration’s popular 504 program, which can provide qualified borrowers with loans of up to 90 percent of a project’s appraised value.
Gary Babbitt is executive vice president, commercial services, for Canandaigua National Bank & Trust. He can be reached at (585) 419-0670, ext. 50645, or gbabbitt@cnbank.com
