Excerpted from "What Every Banker Needs to Know About Working Capital Lending"
Just as commercial paper is created from transactions that occur within the business cycle, collateral
has a cycle in and of itself. Short-term collateral particularly flows from one stage to another. This
cycle is illustrated in the following diagram:
This diagram illustrates the collateral cycle moving from its lowest point under the fixed category or
long-term asset of land all the way up to the most liquid collateral, which is cash. The arrow illustrates
the liquidity of these collateral groups all along the collateral chain.
In the working capital lending arena, the collateral securing a working capital loan is usually
short-term related. Therefore, the collateral or borrowing base consists of accounts receivable, inventory,
and/or marketable securities.
Accounts receivable on the chart consist of consignments, progress billings, or completed
transactions. The only component of accounts receivable that has an established market value would be
the completed transaction. Progress billing and consignments do not have a market-definable value
attached to them and should therefore not be considered for collateral purposes. Inventory would receive
a particular valuation, usually centered on raw materials or finished goods.
The borrowing base created would then have a smaller component for inventory and a larger value
component for receivables — the more liquid the collateral, the higher the value of the borrowing
base percentage applied to that collateral — cash being 1 to 1 and inventory usually running
anywhere from 40 to 50%.
The more liquid the collateral is, the safer the collateral is because it is quickly turned to cash.
Ultimately, a lender, when attempting to liquidate fixed asset collateral
in order to satisfy a defaulted lender obligation, finds that the market determinable value at the time of
sale is generally substantially less than the actual realized value of the forced sale.
In working capital lending, it is critical to match working capital loans to short-term liquid
collateral instead of to less liquid long-term collateral.
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