What is a borrowing base?

The commitment on your loan agreement is a ceiling. The borrowing base is what you can actually draw this week.

The four steps

1. Start with gross collateral. Total accounts receivable, and inventory where the facility includes it.
2. Remove the ineligible portion. Invoices too old, too concentrated in one customer, owed by affiliates or by parties you also owe, and inventory the lender will not lend against. See ineligible receivables.
3. Apply the advance rate. A percentage of what remains, set in the credit agreement and different for each collateral category. See advance rate.
4. Subtract reserves and what you already owe. Reserves cover risks the eligibility rules do not — unpaid rent, accrued payroll taxes, a customer dispute, expected credit notes. Then subtract the outstanding loan balance and any letters of credit.

The result is availability. It is recalculated every time you submit a borrowing base certificate, which may be monthly, weekly or, in a stressed facility, daily.

Why it matters more than the commitment

Illustrative only: a 3,000,000 facility with 900,000 of availability is a 900,000 facility until the collateral changes. Businesses get into trouble here in two ways. The first is planning against the commitment rather than the base. The second is not modelling what happens to the base in a downturn: sales fall, receivables age past the eligibility cut-off, one large customer slows down and trips a concentration limit, and availability drops faster than revenue does.

A full certificate, worked

Gross accounts receivable: $1,450,000.

Ineligible items come off first. $118,000 aged past the cut-off, $96,000 of concentration above the permitted limit for one customer, $22,000 owed by an affiliate, and $34,000 of expected credit notes. That is $270,000, leaving $1,180,000 eligible.

Apply the receivables advance rate of 85%: $1,003,000.

Inventory is $640,000 gross. $190,000 is work in progress, obsolete stock and goods held at a location without a landlord waiver, leaving $450,000 eligible. At a 50% advance rate that is $225,000.

Gross base: $1,228,000.

Reserves come off next — $28,000 for rent at the unwaived location and $41,000 for accrued payroll taxes, so $69,000. Net base $1,159,000.

Subtract the $980,000 already outstanding, and availability is $179,000. That is the figure you can actually draw this week.

What a downturn does to that number

Suppose sales fall 20%. Receivables fall with them, to $1,160,000. At the same time customers slow down, so the over-90 bucket more than doubles to about $259,600, while concentration, affiliate items and credits stay where they were.

Eligible receivables are now $748,400. At 85% that is $636,140. Add the same $225,000 of inventory availability and take off the same $69,000 of reserves: a net base of $792,140.

Against $980,000 outstanding, that is not reduced availability. It is an overadvance of $187,860 — a paydown demand, arriving precisely when the business has less cash than it had before.

Sales fell 20% and availability fell by more than all of it. That is the gearing, and it is why the second mistake above is the expensive one: ageing worsens at the same moment the balance shrinks, and both effects land on the eligible number.

What you can change

More than you would expect. Invoice promptly, because nothing counts until it is billed. Chase the aging before invoices cross the eligibility line. Resolve credits and disputes rather than letting them sit. Watch concentration by customer. Fix the data quality in your aging report, because a lender that cannot reconcile your reports will protect itself with reserves.

The certificate, as a process

The borrowing base certificate is a document you sign, and signing it is a representation.

• Frequency is in the agreement. Monthly is normal, weekly is common in tighter facilities, and daily happens when a lender is worried. It can usually be increased at the lender's discretion.
• It has to reconcile. The aging behind the certificate must tie to the general ledger, and a field examiner will test that it does. A certificate that cannot be reconciled is the fastest route to a reserve.
• Late certificates have consequences. Many agreements suspend availability until delivery, whatever the certificate would have shown.
• Accuracy is a covenant. An overstated base is not treated as an administrative error. It is typically a default, and in a facility carrying a validity-style guarantee it can reach you personally.

What to read in your agreement

The definitions of eligible receivable and eligible inventory, the advance rates, the list of permitted reserves and who decides them, and how much discretion the lender has to change any of it. In most agreements that discretion is broad and described as reasonable credit judgement, which means your credit limit can move without your agreement and without a default.

What to ask before you sign the facility

1. What makes a receivable ineligible? Get the full definition, including the aging cut-off, the concentration limit, cross-aging, foreign accounts, government accounts, affiliates and contra accounts.
2. What reserves may be imposed, and who decides? Ask whether the list is exhaustive or illustrative. "Such other reserves as the lender may determine" is the phrase to notice.
3. How much notice do I get before an advance rate or a reserve changes?
4. What is the overadvance mechanic? Whether a shortfall is repayable on demand, over a stated number of days, or curable with additional collateral.
5. What happens if a certificate is delivered late?
6. Is a seasonal or temporary overadvance available, agreed in advance, for the part of the year you can already predict?

The last one is worth asking early. An agreed seasonal overadvance negotiated while the deal is being written costs a fee. The same accommodation requested in the week you need it costs considerably more, if it is available at all.