Borrowing Base
Definition
A borrowing base is the maximum amount of money a lender is willing to loan to a borrower, typically based on the value of the borrower's assets. It is often used in the context of asset-based lending, where the loan amount is determined by the value of certain assets like receivables, inventory, or equipment.
Lenders typically set a borrowing base by evaluating the value of these assets and applying a percentage to them. This helps to ensure that the loan is backed by tangible, liquid assets that can be used to repay the loan if necessary.
Example
Let’s say a business has the following assets:
Accounts Receivable: $500,000
Inventory: $300,000
Equipment: $200,000
The lender may apply a certain percentage to each of these asset categories to determine the total borrowing base. For example:
80% of Accounts Receivable: 80% of $500,000 = $400,000
50% of Inventory: 50% of $300,000 = $150,000
40% of Equipment: 40% of $200,000 = $80,000
In this case, the total borrowing base would be: $400,000 + $150,000 + $80,000 = $630,000
This means the borrower could access up to $630,000 in credit, based on the value of their assets.
Formula for Borrowing Base
The formula to calculate the borrowing base is:
Borrowing Base = (Receivables × % Lender Allows) + (Inventory × % Lender Allows) + (Other Assets × % Lender Allows)
Where:
Receivables = The value of the accounts receivable (money owed by customers).
Inventory = The value of the business’s inventory.
Other Assets = The value of other assets like equipment, real estate, or intellectual property.
% Lender Allows = The percentage that the lender is willing to use for each asset class (it may vary by asset type).
How Borrowing Base Works in Practice
Inventory and Accounts Receivable: These are the most common assets used in determining a borrowing base. Lenders will usually offer a higher percentage of financing against accounts receivable (because it is more liquid) and a lower percentage against inventory.
Asset Types: Not all assets are included in the borrowing base. Lenders are typically more inclined to lend against assets that are easy to liquidate in the event of default. For example, real estate or equipment may have lower lending percentages, as they are less liquid.
Ongoing Adjustments: The borrowing base is often recalculated periodically, such as every 30 to 60 days, to reflect changes in the value of the assets. This ensures that the loan amount remains in line with the borrower’s current asset value.
Significance of Borrowing Base
Credit Limit: The borrowing base determines the maximum loan amount available to a business. If the business’s assets increase, the borrowing base—and thus the available credit—could increase as well. If the assets decrease, the borrowing base may shrink, reducing the available credit.
Risk Management for Lenders: By tying the loan to the value of the borrower’s assets, lenders reduce the risk of lending. If the borrower defaults on the loan, the lender can seize and sell the assets to recover the outstanding amount.
Working Capital: A business can use the borrowing base to secure working capital. For example, the business may borrow against its receivables to cover short-term cash flow needs while waiting for customers to pay invoices.
Advantages of Using a Borrowing Base
Flexible Financing: A borrowing base provides flexibility for businesses, as it ties the credit available to the business’s tangible assets, which are often key to its operations.
Potential for More Credit: Businesses that have significant assets, such as large accounts receivable or inventory, may be able to access more credit through a borrowing base than they would through an unsecured loan.
Lower Interest Rates: Loans based on a borrowing base may come with lower interest rates compared to unsecured loans because they are backed by tangible assets.
Limitations of Borrowing Base
Asset Fluctuations: The borrowing base depends on the value of the assets, which can fluctuate. If the value of the assets declines, the borrowing base—and the available credit—may decrease, potentially straining the business’s cash flow.
Collateral Requirements: The lender may require specific assets to be pledged as collateral, and in some cases, the business may need to continue maintaining those assets to ensure they meet the borrowing base requirements.
Asset Liquidation Risk: If the borrower defaults, the lender has the right to liquidate the assets used to back the loan. This could potentially impact the borrower’s business operations if the assets are essential to running the business.
Borrowing Base in Different Loan Types
Revolving Credit: In a revolving line of credit, the borrowing base is used to determine the maximum available credit at any given time. The business can borrow, repay, and reborrow as needed, with the credit limit determined by the borrowing base.
Term Loans: For term loans, the borrowing base may be calculated initially to determine the loan amount, but there is typically less flexibility in terms of borrowing and repaying funds.
Conclusion
A borrowing base is a crucial concept in asset-based lending, allowing businesses to access credit based on the value of their assets. It helps both lenders and borrowers manage risk while providing a flexible financing solution. However, businesses must be aware of the fluctuations in asset values and the potential impact on their credit limits. Understanding how borrowing bases work and how they are calculated can help businesses make more informed financial decisions and optimize their access to credit.