Understanding The Concept and Rationale of Standard Accounts Receivable Ineligibles
Determining the eligibility of collateral is a critical part of constructing a secured loan agreement. Neha Malhotra provides an overview of common accounts receivable ineligibles to simplify this common yet technically intensive part of the field examination process.
When the structure of a secured asset -based line of credit is discussed, the conversation surrounding eligibility or ineligibility of collateral often surfaces. While there are many types of collateral, this article will focus on accounts receivable as collateral in the ABL space for commercial and industrial finance.
Specific details about eligible collateral guidelines are a part of complex legal agreements that are signed between the lender and the borrower. When businesses head toward riskier territory, lenders require diligent enforcement of these parts of the agreements.
While low risk borrowers never head into that trajectory, CFOs of higher-risk borrowers may find themselves going through these complex legal agreements, trying to comprehend, implement and conform to the specified document details. While such legal agreements are very specific to the deal made between a borrower and a lender, conceptually, these agreements do tend to follow the concept that anything potentially uncollectible is simply not lendable. To identify the true lendable amount (otherwise known as the net available amount), high risk borrowers must submit a borrowing base and an A/R aging to support the borrowing base.
The lendable amount (net available amount) is calculated after discounting the eligible receivables via an advance rate (calculated based on historical dilution, typically around 80% to 85%). The eligible receivables are then calculated after excluding non-lendable receivables (ineligibles) from total outstanding receivables.
Non lendable or ineligible accounts receivables are receivables that might be potentially uncollectible and hence not lendable. Common ineligibles followed across most financial institutions include past dues, cross age ineligibles, concentration limits, contra against payables, federal ineligibles, foreign ineligibles, cash/COD customers and several others. Let’s take a look at some of the most common:
Past dues are invoices or receivables that have not been collected in a reasonable time frame. Across the ABL industry, a reasonable timeframe is generally considered three times the standard customer payment terms. So, for example, if the borrower offers standard payment terms of net 30 days to its customers and a customer has not paid its invoice in 90 days from invoice date (three times the terms) or 60 days from the due date (invoice date plus the standard payment term), it is reasonable to assume there might be issues with collectability of the receivable.
There could be a variety of issues leading to past due payments such as issues with shipments or the customer’s financial situation. Regardless of the reason, the end result will include receivables becoming potentially uncollectible or past due, forcing a lender to categorize them as ineligible or non-lendable.
Defining the time frame for when invoices or receivables will become past due is a major aspect to determine during the construction of a loan agreement, as not every situation will call for the same approach. The example just discussed (past dues are unpaid invoices past 90 days from the invoice date or 60 days from the due date) might be a perfect fit for a toy company with customer payment terms of net 30 days, but it may not be a good fit for an agriculturally-based food company with Perishable Agricultural Commodities Act (PACA) terms of net 10 days or a seasonal he-based product company with terms of net 90 days.
Cross Age Ineligibles
Cross age ineligibles are intended to filter out “at-risk” receivables, or receivables of which a significant percentage are past due. Based on the loan agreement between the lender and the borrower, if an account receivable has a significant past due balance (for example, 20%), the entire outstanding receivable balance from that customer is treated as at-risk and considered to be cross age ineligible. This helps the lender to exclude at-risk accounts that may be slow paying, might have cash flow issues or could create a strained business relationship. All these situations can potentially risk the collectability of the receivables and are therefore considered ineligible or non-lendable.
Concentration limits are an ineligible category implemented to limit the business risk arising from substantial exposure caused by sales to a single large customer. Concentration ineligibles are calculated as excess amounts over an allowed limit amount. For example, if a borrower has total accounts receivables of $100 with a concentration limit of 20%, then up to $20 on each customer would be eligible and lendable, while any excess balance of more than $20 from one customer would be held ineligible. To elaborate, if a borrower has a customer with outstanding receivables of $30 (or 30%) of the total accounts receivables, then 20% (or $20) would be lendable and the excess $10 would be a concentration limit ineligible amount. The rationale behind this concept is since a significant amount of sales comes from one customer, the borrower’s business operations might rely too significantly on that one customer. In the future, if the borrower loses the customer or if sales are substantially reduced, the borrower might struggle to replace its sales volume, which might create an overall business risk. The reduction in sales also would put the outstanding loan provided to the borrower at risk, as the collateral (receivables) supporting the loan would be diminishing. Hence, to effectively manage business risk, concentration limits are placed on balances due from individual customers.
Payable Contra Offsets
Payable contra offsets are calculated to exclude customers who are also vendors with amounts due to be paid. In a liquidation scenario, if there is an outstanding payable amount due to the borrower, the vendor/ customer most likely will only pay the outstanding receivable amount after reducing for any payable amount. Hence, to eliminate the risk of potential receivable reductions, contra offset ineligibles are held. Contra offset ineligibles are calculated based on the lower amount of the payable or otherwise eligible amount.
COD/cash accounts are calculated to exclude customers that have not been granted credit terms. If an account was deemed to be a cash-on-delivery account, the amount will be due on the same day inventory is shipped. As such, a balance for an outstanding receivable is likely uncollectible, should not be on the receivable aging and hence should be deemed ineligible.
Foreign accounts are receivables due from debtors that are domiciled outside the U.S. (and, in some instances, Canada). Since these accounts are domiciled outside U.S. jurisdiction, U.S. laws (and UCC filings) are not applicable or enforceable. In a liquidation scenario, it might be challenging to enforce security laws because of jurisdictional limitations.
Federal accounts are receivables that are due from various departments of the U.S. federal government. Despite being excellent credits, these receivables are deemed non-lendable by most lenders unless there is an assignment of claims in place. In a liquidation scenario, lenders require customers to pay directly to the lender so that the loan amount is recovered. Unless there is an assignment of claims in place, the U.S. federal government is not required to pay the lender and can pay the borrower directly. If the borrower does not forward the receivable to the lender, the collectability of the receivables is at risk, making the receivables ineligible or non-lendable. After an assignment of claims is transferred to the lender, the lender becomes a priority payable instead of the borrower, so with the assignment of claims, the amount is lendable.
Apart from these common categories, there could be other industry specific (deferred revenue for services), debtor’s operational specific (prebills, consignment sales) and deal specific (open allowances) ineligibles. As such, the ineligible categories listed in this article are not comprehensive or exhaustive in nature. They tend to vary based on various factors and the terms of the final agreements made between the lender and the borrower.
ABOUT THE AUTHOR: Neha Malhotra is an experienced field examiner in the asset-based lending and factoring industry. With master’s degrees in finance from Texas Tech University and the University of Mumbai, Malhotra has a decade of experience and has worked with multiple financial institutions in the commercial lending space.