Secured Lending: Rules of Thumb for the

Manufacturer
There are several rules of thumb used by bankers in making secured lending decisions and
managing loans. Manufacturers should understand these rules so that they can monitor their credit
ratings and maintain their ability to borrow on favorable terms.

Ideally, the loan would be made against accounts receivable, with inventory held in reserve as
supplementary collateral. Anything that decreases the quality of the primary collateral (accounts
receivable) will be viewed very negatively.

Accounts Receivable
Collectibility. Commercial banks typically lend up to 80 percent of acceptable accounts receivable.
The key word is “acceptable,” which is synonymous with collectible. Accounts that are “seriously
past due” are generally considered unacceptable for borrowing purposes. Most banks consider an
account seriously past due when it exceeds 300 percent of the net terms offered. Thus, an account
due 30 days after delivery would be deemed seriously past due after 90 days.

Unacceptable accounts receivable should not exceed ten percent of total receivables. This rule of
thumb is an indicator of the overall quality of a manufacturer’s credit and collection department.

Quality. The quality of accounts receivable is measured by receivable turnover, sales dilution, and
receivable concentrations. Generally, bankers become uncomfortable when accounts receivable
turnover exceeds 150 percent of the industry norm. For example, if the average collection period in
your industry is 38 days, then 57 days or more would be considered excessive.

Dilution refers to the difference between billed and collected receivables. The main causes of
dilution are bad debt expense, returns and allowances, and billing errors. If dilution exceeds five
percent of sales, many bankers become concerned about collectibility and may not allow an 80
percent advance rate.

In general, bad debt expense should not exceed one percent of sales; returns and allowances
(including defects) should not exceed one percent; and billing errors and other receivables problems
should be under one-half of one percent. Although these limits may appear harsh to many
manufacturers, bankers consider dilution to be a major cause of uncollectibility.

Concentrations of receivables also concern bankers. When a significant portion of the borrower’s
business is attributable to a small number of customers, the risk of nonpayment and loss of sales
becomes more significant. Most bankers become uncomfortable when a single customer accounts
for more than ten percent of total receivables. This requires extra attention and credit information to
monitor the account.

© 2009 Principa. All Rights Reserved. 61

 Secured Lending: Rules of Thumb for the
Manufacturer (Cont’d)
Inventory
Inventory is considered secondary collateral because it is usually less liquid than accounts receivable. Most banks prefer
to maintain inventory loan balances at one-half or less of receivable loan balances. Inventory loan balances are limited
in two important ways:
1. Inventory advance rates generally do not exceed 50 percent of acceptable inventories, and
2. There is almost always a maximum amount the bank is willing to lend against inventory, called an
inventory cap.

“Acceptable inventory” means saleable inventory. Examples of unacceptable inventory are:

•Work in progress
•Slow-moving, obsolete, or off-brand inventory
•Damaged or recalled inventory.

An exception may be made for work in progress if it is saleable in its current form or if the manufacturing time to
complete the finished product is particularly short. Generally, unacceptable inventory should not exceed ten percent of
total inventories.

The rules of thumb used to determine inventory quality include inventory turnover, accounting systems, and
merchantability. Like accounts receivable turnover, inventory turnover time should not exceed 150 percent of the
industry norm. Some banks require turnover information on individual product lines for comparison with industry data.

A perpetual inventory accounting system is extremely important to bankers. Many banks refuse to consider higher
advance rates or seasonal overadvances without a good inventory tracking system. Don’t expect your banker to view
inventory as a liquid commodity that can be sold with a few phone calls. This same banker has probably experienced the
frustration of trying to liquidate inventory that was on the books but not in the warehouse.

Merchantability refers to the ease with which inventory can be sold and the price it can command. Commodities and
certain branded products or materials are most liquid and hold value even in a distress situation. Advance rates against
this type of inventory sometimes exceed 65 percent and the loan balance may even be greater than the accounts
receivable balance.

Borrowing Level
There is one final rule of thumb that manufacturers need to know. If the company consistently borrows more than 90
percent of its daily available borrowing base, the bank may consider the manufacturer to be relying too heavily on the
bank for capital.

Although the bank’s comfort level may be higher if the borrower’s trade payables are relatively current, continually high
borrowing levels eventually will prompt the bank to undertake remedial action to alleviate the borrower’s working
capital shortage.

Conclusion
The most important thing to remember about rules of thumb is that they are just that-rules of thumb. They serve as
guides in managing borrowing capacity, but it is important to determine the rules that will be applied to your particular
financial situation.

© 2009 Principa. All Rights Reserved. 62