We often tell our clients that a company does not file for bankruptcy on a particular day because it has too much leverage, or because it has a bad management team, or because it has a competitive disadvantage. All of these factors may eventually drive a company out of business, but the reason a company files for bankruptcy on a particular day is liquidity: they run out of cash. Therefore, it is important to measure a company’s liquidity as part of any comprehensive financial analysis (one of our favorite tools is the liquidity position).
For many companies, availability under a committed, revolving line of credit is a key source of liquidity. Here’s an example:
In 2010, Sears Canada entered into a five-year $800 million senior secured revolving credit facility. As of January 28, 2012, they had borrowed $101 million under that facility. How much additional can they borrow using that revolver?
a) $699 million
c) Something between $699 and zero
The answer is … you don’t have enough information to give an answer. According to Sears, they have $415 million available.
Here are the factors that determine how much you can borrow on a revolver:
- How much you have already borrowed. In the Sears example, it would reduce availability to $699 million
- Letter of Credit usage. Many revolvers can also be used for letters of credit. This allows companies to issue letters of credit without getting credit approval for each one individually. However, letters of credit issued under a revolver reduce borrowing availability under that revolver. In the Sears example, they had approximately $284 million of letters of credit outstanding under the revolver. When added to the $101 million of borrowings, it reduce availability under the revolver to $415 million.
- Covenants. If a company is in default under its credit agreement (for example, because it breached a covenant), it automatically blocks any additional borrowing under a revolver (because it can not satisfy the “conditions to borrowing,” one of which is an absence of default). In addition, if the borrowing itself would put the company into default (for example, by increasing leverage above the leverage covenant), the company may not borrow. In our example, Sears is not in default (but if they were, the answer would be zero). It is interesting to note that a default does not automatically require the company to repay the existing borrowings – lenders must affirmatively act to accelerate (or “call”) the loan.
- The Borrowing Base. According to Sears, “Availability under the Sears Canada Facility is determined pursuant to a borrowing base formula based on inventory and account and credit card receivables, subject to certain limitations.” So even if there were no borrowings and no letters of credit, and even if the company was in compliance with all covenants, they might not be able to borrow the full amount of the facility, because of the borrowing base.
Here’s how a borrowing base works:
- Review the company’s accounts receivable and inventory. Are there any items that are likely worthless (e.g. past due, disputed or related party receivables; obsolete or work-in-process inventory) or unable to be pledged (e.g. inventory or receivables in other countries)? These items are referred to as “ineligible” and are removed when calculating the borrowing base.
- Apply an “advance rate” or discount to the remaining “eligible” items. This discount reflects the likely decline in asset values in a stress scenario and the cost to the lender to foreclose and sell the collateral. Typical advance rates are 50% for inventory and 75% for accounts receivable.
- Once the ineligible items are excluded and the advance rate is applied to the remainder, you end up with the borrowing base amount. The revolver must, at all times, be at or lower than this number (even if it is less than the stated amount of the revolver). For Sears, the borrowing base was not a limitation (i.e. the borrowing base was larger than the commitment amount). Here’s an example of how a borrowing base might work (not Sears):
Asset based lenders (”ABL”) use a borrowing base all of the time. It is also very common among small and middle-market borrowers. It is typically not used for loans to large corporate borrowers (except if they are borrowing in the ABL market).
So how much can a company borrow under its revolver? It depends.