The borrowing base explained: eligibility, advance rates, dilution and the certificate

A cash-flow loan is sized once, at closing, to a projection of what the business will earn. An asset-based loan is sized continuously, to what the business owns and could sell. The instrument that does the sizing is the borrowing base, and understanding it is understanding asset-based lending.

The formula

The borrowing base is the maximum a borrower may have outstanding at any moment. It is computed from the bottom up. Start with gross collateral in each class, typically accounts receivable and inventory, sometimes equipment. Remove what is ineligible. Multiply what remains by an advance rate for that class. Add the classes together. Subtract reserves. The result is availability, and the borrower may draw up to it. Outstanding loans above it are an over-advance that must be cured, usually by paydown within a few days.

Each step encodes a judgment about what a liquidator could realize. The Office of the Comptroller of the Currency’s Comptroller’s Handbook booklet on asset-based lending frames the whole discipline that way: the lender’s protection is the collateral, so the lender must know at all times what the collateral is worth and be able to reach it.

Eligibility: what a liquidator could not sell

Eligibility rules remove collateral that exists on the books but would not produce cash in a liquidation. For receivables, the standard exclusions are invoices older than an agreed number of days from invoice date, invoices from a debtor where more than an agreed share of that debtor’s balance is past due, which is the cross-aging rule, invoices owed by affiliates or related parties, invoices subject to a contra account where the debtor is also a supplier and could offset, disputed invoices, progress billings, bill-and-hold sales, foreign debtors without insurance or letters of credit, and government receivables unless the assignment has been perfected under the applicable assignment-of-claims procedure. Balances above a concentration limit for any single debtor are ineligible too, because a pool dominated by one payer is a loan to that payer.

For inventory the exclusions follow the same logic: work in progress, slow-moving and obsolete stock, consigned goods the borrower does not own, goods at third-party locations without a landlord waiver or bailee letter, and goods subject to a vendor’s purchase-money security interest.

Advance rates: the haircut for uncertainty

The advance rate is the share of eligible collateral the lender will fund. It reflects how reliably the class converts to cash and how much it costs to convert. Eligible receivables from creditworthy commercial debtors convert reliably and cheaply, so they carry high advance rates. Inventory carries lower ones, because selling it takes time, money and a buyer. For inventory and equipment the rate is usually expressed against net orderly liquidation value, an independent appraiser’s estimate of what the assets would fetch in a managed sale over a reasonable period after the costs of the sale, rather than against cost or book value.

Dilution: the gap between invoice and cash

Dilution is the difference between the gross amount invoiced and the cash finally collected, arising from returns, credits, disputes, early-payment discounts, warranty claims and write-offs. A borrower with high dilution has receivables worth less than their face value in a way that an aging report will not show. Lenders measure it through a receivables roll-forward, reconciling opening balance plus sales less collections to the closing balance and identifying every non-cash reduction along the way, and they hold a dilution reserve against the base sized to that history. A rise in dilution is one of the earliest signs of a deteriorating business, because it usually means customers are pushing back on what they were billed.

Reserves: what ranks ahead

Reserves are deducted for claims that would rank ahead of the lender at a liquidation or reduce what it could collect: unpaid payroll and sales taxes, rent owed to landlords who hold a lien on goods at their premises, warehouse fees, customer deposits, and the dilution reserve above. They are the lender’s acknowledgment that even a perfected first-priority lien is not first against everything.

The certificate

The borrowing base certificate is the document that makes all of this operational. Prepared and signed by the borrower on a fixed cadence, weekly for a fast-turning receivables book and monthly for slower inventory, it schedules gross collateral, ineligibles, the advance calculation, reserves and resulting availability, and it is accompanied by the agings and inventory reports that support it. Signing a false certificate is a default and, in most credit agreements, a personal exposure for the officer who signed it.

Field exams: trusting, then verifying

The certificate is the borrower’s assertion. The field examination is the lender’s test of it. Before closing and on a regular cycle afterward, examiners visit the borrower, roll the receivables forward to measure turnover and dilution, trace sample invoices to shipping documents and cash receipts, count and test inventory, confirm that payroll taxes are current, and compare every figure on the certificate with the books. As practitioners writing in The Secured Lender describe, the tools have changed and the purpose has not: to confirm that the collateral the lender is advancing against exists, is what it is said to be, and would produce cash if it had to.

The borrowing base is often described as restrictive. It is better described as honest. It says exactly how much a lender is willing to lose if everything else goes wrong, and it says it again every week.