Accounts Receivable And Inventory Financing

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A-ARComptroller of the CurrencyAdministrator of National BanksAccounts Receivableand Inventory FinancingComptroller’s HandbookMarch 2000AAssets

Accounts Receivableand Inventory FinancingTable of ContentsIntroductionOverviewRisks of Accounts Receivable and Inventory FinancingCredit Risk Rating ConsiderationsTypes of Accounts Receivable and Inventory FinancingAccounts Receivable and Inventory Financing StructuresRevolving Credit“Permanent” Working CapitalSeasonal Operating AdvancesOver-advancesTerm DebtEvaluating the BorrowerAssessing the Borrower’s Financial PositionAssessing the Borrower’s Operating CycleAssessing the Borrower’s IndustryAssessing the Borrower’s Management TeamEvaluating CollateralAccounts ReceivableInventoryUnderwriting ARIF LoansCollateral Controls in the Loan AgreementDocumentationFinancial CovenantsThird-Party Guarantees or InsurancePricingAdministering ARIF LoansDisbursing Revolving Loan AdvancesMonitoring SystemsSpecialty Financing ArrangementsStructured FinanceDebtor-in-possession FinancingFactoringThird-Party VendorsComptroller’s 2728283131323334Accounts Receivable and Inventory Financing

Compliance IssuesDebt Liquidation and Lender LiabilityState and Federal Laws, Rules, and RegulationsAllowance for Loan and Lease Losses35353536Examination ProceduresGeneral ProceduresQuantity of RiskQuality of Risk ManagementConclusions3737404956AppendixesA. ARIF Summary ChartB. Trade Cycle Analysis WorksheetC. Adverse Risk Rating Examples58585960Glossary69References75Accounts Receivable and Inventory FinancingiiComptroller’s Handbook

Accounts Receivableand Inventory FinancingIntroductionThis booklet describes the fundamentals of accounts receivable and inventoryfinancing (ARIF). The booklet summarizes ARIF risks and discusses how a bankcan prudently manage these risks. One of a series of specialized lendingbooklets of the Comptroller’s Handbook, “Accounts Receivable and InventoryFinancing” supplements the general guidance in the “Loan PortfolioManagement” and “Commercial Lending” booklets.OverviewARIF is the most fundamental form of “collateral-based” commercial lending. Itcombines elements of secured lending and short-term business loans. In itspurest form, commercial borrowers use the value of their receivables andinventory (working assets) as collateral to secure financing to produce andmarket their products and services. The financing is then repaid by convertingthe inventory to cash, either directly or through the collection of an accountsreceivable invoice. Depending on the risk profile of the borrower, lendersexercise varying degrees of control over collateral to manage the credit risk inthe transaction.Over time many variations of ARIF have developed. The collateral base maynow include assets other than receivables and inventory, controls overcollateral have been modified, and repayment sources have been expandedbeyond the conversion of working assets. In addition to providing funds tofinance inventory, ARIF loans are used to finance acquisitions, to restructuredebt, and to tide companies through periods of distress. Manufacturers,wholesalers, distributors, retailers, importers and service organizations all useARIF to meet their business needs. Although ARIF has undergone change, itremains essentially a means for borrowers to leverage assets to obtainfinancing.As the structure of ARIF loans has been modified, the availability of ARIF hasalso expanded. Once the province of a small group of specialized lenders,ARIF is now offered by most large and mid-sized banks and many communitybanks. Borrower demand for more credit availability and banks seekingopportunities to expand their loan portfolios have spurred this growth.However, as discussed below, this type of specialized lending carries with it ahigher degree of risk than most other types of commercial lending. As a result,Comptroller’s Handbook1Accounts Receivable and Inventory Financing

ARIF loans require more intensive controls and supervision. ARIF has severalunique features. Most particularly, the source of repayment of these loans isdedicated cash flows from the conversion of working assets, unlike mostcommercial loans where the source repayment is cash flow from operations.(For a more compete discussion of cash flows, see the section below on“Assessing the Borrower’s Operating Cycle.”) The controls applied to collateraland cash receipts also differentiate ARIF loans from other types of commercialloans.Most ARIF relationships exhibit moderate to high risk. Borrowers typicallyturn to ARIF when they cannot obtain other types of financing. ARIF borrowersmay not be as strong financially as other commercial borrowers, they mayoperate in industries with high volatility or significant seasonality, or they maybe experiencing rapid growth. These borrowers exhibit higher risk of defaultcharacteristics such as:CHigh leverage.CErratic or marginal profitability.CLimited working capital and cash reserves.CConstantly changing collateral pools whose value can fall quickly.Properly structured ARIF transactions mitigate the risk of default by imposingcontrols on collateral and cash. When an ARIF loan is properly margined andthe bank applies prudent monitoring and control processes, the risk of lossactually can be less than for other types of commercial lending. The key is inexercising the degree of control necessary to manage and mitigate the risks —the higher the risk, the greater the control needed. To achieve control, lendersneed significant management expertise, a thorough understanding of theborrower’s business, good reporting systems, and ongoing supervision of thecollateral and the relationship.Because of the higher intrinsic default risk in ARIF loans, ARIF units oftenreport higher levels of adversely rated loans than other commercial lendingunits. This is expected. By the same token, the collateral support andadministrative controls used to manage these loans, particularly in wellmanaged ABL units, often results in lower losses. The lower loss experienceshould be reflected in the allowance provision and in capital allocations ininternal risk models.Accounts Receivable and Inventory Financing2Comptroller’s Handbook

Risks of Accounts Receivable and Inventory FinancingFrom a supervisory perspective, risk is the potential that events, expected orunanticipated, may have an adverse impact on a bank’s capital or earnings. TheOCC has identified nine categories of risk for bank supervision purposes:credit, interest rate, liquidity, price, foreign currency translation, transaction,compliance, strategic, and reputation. While ARIF has all these risks, thisbooklet will focus on credit, transaction, and compliance risk. For a completediscussion of the other risks, refer to the “Loan Portfolio Management” bookletand the Comptroller’s Handbook for National Bank Examiners.Credit RiskCredit risk is the current and prospective risk to earnings or capital arising froman obligor’s failure to meet the terms of any contract with the bank orotherwise to perform as agreed. Credit risk arises any time bank funds areextended, committed, invested, or otherwise exposed through actual or impliedcontractual agreements, whether reflected on or off the balance sheet.Like other types of commercial lending, ARIF’s most significant risk is creditrisk. ARIF borrowers typically exhibit higher default risk than other commercialborrowers. Credit risk is present in every part of the lending cycle — initialcredit evaluation, underwriting, loan approval, loan administration, and, ifnecessary, debt liquidation.Transaction RiskTransaction risk is the current and prospective risk to earnings and capitalarising from fraud, error, and the inability to deliver products or services,maintain a competitive position, and manage information. ARIF has elevatedtransaction risk because of the complexity of the products and the internalcontrol environment. The risk encompasses product development and delivery,transaction processing, systems development, computing systems, employeeintegrity, and operating processes. Transaction risk can also develop whenmanagement or staff does not provide sufficient oversight.Transaction risk in accounts receivable and inventory financing is primarilyposed by: Internal operations of the lending department, including the need to properlyperfect liens under the Uniform Commercial Code (UCC). Internal operations of the borrower.Comptroller’s Handbook3Accounts Receivable and Inventory Financing

The potential for fraud on the part of the borrower. The failure to properly oversee ARIF computer software products offered bythird-party vendors, if applicable.Compliance RiskCompliance risk is the risk to earnings or capital arising from violations of ornonconformance with laws, rules, regulations, prescribed practices, or ethicalstandards. Compliance risk also arises in situations where the laws or rulesgoverning certain bank products or the activities of the bank’s clients may beambiguous or untested. Because ARIF departments exert a significant amountof control over the borrower’s working assets, this type of lending can be morevulnerable to compliance risk. This booklet discusses compliance risk posedby: Noncompliance with federal and state laws, rules, and regulations. Forexample, a borrower may suffer financial setbacks if it violates or fails toconform to laws governing environmental contamination, health, safety, orfair labor. Litigation and other legal remedies (for example, lender liability actions) thatmay arise when the lender seeks to have a debt liquidated.Credit Risk Rating ConsiderationsConsiderable debate has surrounded the issue of whether the uniform interagency classification guidelines are appropriate for rating ARIF loans. OCCpolicy is to apply the uniform interagency rating definitions, as contained in the“Classification of Credits” section of the Comptroller’s Handbook. Thesedefinitions take into account both risk of default and risk of loss in the event ofdefault. Risk of default is generally a matter of the financial strength of theborrower, while risk of loss upon default is generally a matter of the quality ofunderwriting (terms, collateral, covenants, etc.).When applying the credit rating definitions to individual loans, examinersshould remember that ARIF is a type of secured lending. Decisions on riskratings must take into account whether sources of repayment will producesufficient cash flow to service the debt as structured, collateral value, andcollateral liquidity. Any laxity in the bank’s monitoring and control of thecollateral can diminish the protections afforded by collateral and lower a loan’sAccounts Receivable and Inventory Financing4Comptroller’s Handbook

risk rating. Inappropriate structure can also be a significant factor in assigningan adverse risk rating.Borrowers whose loans are administered in dedicated ARIF units, particularlyasset-based lending1 (ABL) units, often have high leverage and/or erraticearnings or losses. These characteristics are often the norm for ARIFborrowers; their presence does not necessarily warrant an adverse risk rating,but may do so if conditions deteriorate further.More pertinent to the loan’s rating is comparison of the borrower’s actualperformance with what was expected when the loan was underwritten. If theborrower repeatedly fails to meet earnings projections, has a trend of heavylosses or excessive leverage, needs internally approved over-advances toofrequently or for too long, fails to provide timely financial information(including inventory and receivable aging information) fails to perform onrelated debt, or unexpectedly needs to access debt outside the ARIF line, theloan is a candidate for an adverse risk rating. An adverse rating may also beappropriate if the bank must adjust advance rates or change definitions ofeligibility, including the addition of fixed assets to the borrowing base, to keepthe loan within formula (see glossary). If liquidation of collateral (e.g., a forcedsale by the bank or borrower), is an ARIF loan’s most likely source ofrepayment, the loan would normally be classified as substandard at best.Some industry participants contend that ARIF loans, especially thoseadministered in well-controlled ABL units, should be assigned a more favorablerisk rating than a loan with similar earnings and balance sheet characteristicsbecause of the existence of collateral and the dedicated staff’s oversight. Such ablanket system of applying risk ratings is not appropriate — in the same waythat it is not appropriate to assign an adverse risk rating simply because an ARIFborrower has low or deficit net worth or occasional losses. While propercontrols help to moderate the risk of asset-based lending, they do not bythemselves overcome well-defined credit weaknesses.Additional guidance on risk rating ARIF loans is provided in appendix C, whichincludes examples of adversely rated credits and the ratings’ rationale.1A specialized form of ARIF in which lenders exercise close control over credit availability andcollateral by setting a borrowing base, controlling cash receipts, and carrying out field audits.Comptroller’s Handbook5Accounts Receivable and Inventory Financing

Types of Accounts Receivables and Inventory FinancingBecause ARIF has many possible structures, the banking industry has manydifferent definitions. This booklet divides ARIF into four types based on thelevel of monitoring and control. Regardless of the specifics of each category,examiners should focus on whether the monitoring and controls are adequatefor the types of ARIF lending conducted by the bank. The four categories aredefined as follows:Asset-Based Lending (ABL) — A relationship in which lenders closely controlcredit availability and collateral. Asset-based lenders use a borrowing-baseformula (derived by multiplying the value of eligible collateral by an advancerate or discount factor), control cash receipts, and carry out field audits.Borrowers often require daily loan advances to operate their businesses andlenders make daily adjustments to the available credit. Collateral consistspredominately of accounts receivable and inventory. Because greater emphasisis on collateral (than in cash flow lending), ABL is structured so that collateralwill be readily available if the loan must be liquidated. ABL is sometimesreferred to as “commercial finance” or “fully followed” lending.Secured Financing — Lending against a borrowing-base formula with lessrigorous collateral controls and monitoring than in ABL. Loan advances are lessfrequent than in ABL. Although collateral is primarily accounts receivable andinventory, other kinds of assets also underpin the loan. The lender’s controlsgenerally consist of periodic accounts receivable agings, periodic inventoryreports, and occasional field audits. The loan and security agreement normallyrequire a properly authorized corporate officer to submit periodic certificationsattesting to the accuracy of the borrowing base information. The borrower hasgreater control of the collateral than in ABL and usually has full access to thecash receipts. Borrowers are usually stronger financially than in ABL, enablingthe bank to ease administrative controls.Blanket Receivables Lending — Asset-types other than accounts receivable andinventory that are often included in the collateral pool. Advances are not tiedto borrowing-base formulas. Controls are minimal, and monitoring of thecollateral is informal. Collateral valuations may be based on financialstatements.Factoring — The lender purchases receivables outright, with or withoutrecourse.Accounts Receivable and Inventory Financing6Comptroller’s Handbook

Although any loan with a lien against current assets, such as a blanketreceivables loan, is technically ARIF, this booklet is primarily concerned witharrangements in which lenders closely monitor and control collateral.However, many of the issues discussed in this booklet, including those relatedto collateral valuation and quality, are relevant for examiners evaluating other,less-controlled loans secured by liens on receivables and inventory. This isespecially true if the loan appears likely to develop into a problem situation.The following sections of the booklet describe how ARIF loans are underwrittenand managed. The booklet distinguishes further between the practices of ABL,secured financing, and blanket receivables lending. (See appendix A for thecharacteristics of each type.)Accounts Receivable and Inventory Financing StructuresSince ARIF loans can be structured in many different ways, lenders shouldunderstand what structure is best suited to the characteristics of the borrower’sbusiness. For example, should the loan be long-term or seasonal? Should it be“fully followed” or “desk-followed” (see glossary)? The purpose of the loan, theanticipated source of repayment, the creditworthiness of the borrower, and thecash operating cycle of the business will help determine the structure of anARIF loan.ARIF lenders will sometimes extend loans secured by fixed or other assets.They may even make unsecured loans. These loans may be separateagreements or part of complex “structured” loan agreements. The term“structured finance” is used to describe an arrangement that has more than onelayer or type of debt. (Structured finance is discussed in this booklet’s“Specialty Financing Arrangements” section.) ARIF lending structurescommonly include revolving credit, “permanent” working capital, seasonaloperating advances, over-advances, and term debt.Revolving CreditA revolving line of credit (revolver) is the most common type of ARIF loan. Arevolver normally supplies working capital. Cash from the conversion ofinventory and receivables repays the debt. The loan agreement defines theamount of control the lender will have over the collateral and cash proceeds.Examiners should determine whether the necessary controls exist and whetherthey are properly exercised.Comptroller’s Handbook7Accounts Receivable and Inventory Financing

Generally, the borrower is expected to apply cash-collateral proceeds to therevolver, but some secured lending arrangements are underwritten with theunderstanding that the borrower can use cash-collateral proceeds for otherpurposes without first applying proceeds against the revolver. Because sucharrangements pose greater risk, the lender should have stronger controls. Forexample, the bank might obtain borrower certifications and carry out periodicfield audits.In a typical revolver, a borrower can draw against the credit as many times asneeded up to the lesser of the available borrowing base or the note amount. Theloan amount outstanding fluctuates with the cash needs of the borrower,subject to the availability constraints of the borrowing base. Credit availabilityis restored when the borrower makes principal payments or borrowing basecollateral is augmented. For the credit to remain available, a borrower mustcomply with terms and conditions stipulated in the loan agreement.The terms of a revolving credit facility can vary considerably. Maturities,which are usually from one to three years, have recently been extended to asmany as five years. A demand feature and other discretionary controls allowthe lender considerable flexibility and control. Some revolvers are converted toterm loans after a specified period. Revolvers may also contain sub-limits orover-advance provisions to meet specific needs of the borrower.“Permanent” Working Capital“Permanent” working capital loans, which fund business operations, newgrowth, acquisitions, and other general purposes, make up much of an ABLunit’s core business. The unit makes what is more akin to an injection ofequity capital than a loan; the borrower is usually highly leveraged and relieson the value of the pledged collateral to support the added credit risk. The ABLunit do

Structured Finance 31 Debtor-in-possession Financing 32 Factoring 33 Third-Party Vendors 34. Accounts Receivable and Inventory Financing ii Comptroller’s Handbook . Comptroller’s Handbook 1 Accounts Receivable and Inventory Financing Accounts Receivable and Inventory Financing Introduction This booklet describes the fundamentals of .

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