In all the analysis, financial information and paperwork, its easy to lose sight of what is probably the most important part of any credit deal – if you don’t want to lose money, that is!
It’s cash that repays debt
When I was a credit manager back in the dark ages, I used to get really annoyed with relationship managers telling me in their credit applications that “the source of repayment is profit”.
How many times did I have to tell them that debt is repaid from cash, not profit? Answer: Lots
If you’re not sure, read my article, Profit Or Cash Flow; Which Is Most Important For A Lender?
So, just to be very clear. When you are assessing a business credit application your first concern is whether the business will generate enough cash flow to repay. And that’s a big challenge sometimes because, as we’ve seen with the Covid-19 situation, events happen that can disrupt even the best plans.
What’s the secondary source of repayment?
That said then, the point I want to make is that a good credit manager will make sure that the bank doesn’t rely only on the cash flow of the business to repay the debt. Even in normal times, there’s no guarantee that expected cash flow will materialise for a variety of reasons.
What is critically important in every credit deal is to make sure that there’s a secondary source of repayment just in case there’s an unforeseen problem with cash flow.
Does every credit deal require collateral?
So, does that mean we have to demand collateral for every deal? Absolutely not. What we have to do is to identify that secondary source of repayment and decide whether we can rely on it still being there should the business face cash flow difficulties in the future.
For example, let’s say that we’re assessing a manufacturing business. There will probably be a significant amount of fixed assets in the balance sheet that would have some value.
If all of those assets were used in the manufacturing process and we expected the business to liquidate those assets to repay our debt because they failed to receive the cash flow it expected, would that be the ideal situation?
Obviously, if the business did that it would hamper its productivity and may not be the best course of action in the long run. However, if some of the fixed assets were not productively used (vehicles, for instance) and could be sold without impacting the manufacturing process, then perhaps that could work and we would be repaid from that source.
Alternatively, if the business didn’t have assets of any value, perhaps we could look to the owners in their personal capacities to determine whether their personal assets could provide the comfort we need. The next issue, of course, would be whether they’re happy to put those assets on the line in support of their personal guarantees for the debt.
Why we would take collateral
If we have identified the secondary source of repayment, the question to answer then would be: “will those assets still be there if the business gets into cash flow difficulties?”
In some cases, particularly when we think about current assets such as inventory, a business would be disposing of its easily-saleable assets to generate cash flow in the short-term if it was in trouble. Those assets are very rarely of any value to the bank in a distressed situation.
The same might apply to fixed assets if the business was in deep trouble. And, of course, the owners of the business would certainly be moving their personal assets into other names or, at least, hiding them if they thought they could lose them if the bank forced their sale.
So, it’s when we think that there’s a chance the secondary source of repayment may not be available to us in times of financial distress that we should be taking legal control of those assets. That’s when we should decide at the outset to use those assets as collateral for the debt. Simply so that we can ensure the assets will not be sold-off until our debt is repaid.
Having a secondary source of repayment will not always guarantee that every debt will be repaid, but it does improve your chances since you now have two options instead of just the one that you’d otherwise have.