Credit Analysis

Asset-Based Lending, Borrowing Bases and Field Exams

Asset-based lending provides revolving credit secured by a borrower's receivables and inventory, with availability set by a borrowing base. The lender applies advance rates to eligible collateral, subtracts reserves and monitors the collateral through frequent reporting, field exams, inventory appraisals and control of cash collections, relying on collateral liquidity more than enterprise value.

What is asset-based lending?

Asset-based lending is a form of secured credit in which the amount a borrower may draw is tied directly to the value of specific, liquid collateral, usually accounts receivable and inventory, and sometimes machinery, equipment or real estate. Instead of relying primarily on a multiple of EBITDA, the lender asks how much it could recover by collecting receivables and liquidating inventory if the business failed. This makes asset-based lending suitable for companies with significant working capital, seasonal or cyclical earnings, thin margins, or a turnaround story that cash flow lenders would not finance.

Because availability expands and contracts with the collateral, an asset-based revolver is self adjusting. When sales grow, receivables and inventory grow, and the borrower can draw more. When sales fall, availability shrinks automatically, which forces deleveraging before the lender's exposure outruns its collateral. This feature is what allows asset-based lenders to operate with lighter financial covenants than cash flow lenders, often relying on a springing fixed charge coverage test that applies only when availability falls below a threshold. The lender's comfort comes from the collateral and the controls around it rather than from earnings stability.

How is a borrowing base calculated?

The borrowing base starts with gross collateral, removes ineligible items, applies advance rates and then subtracts reserves. For receivables, ineligibles typically include invoices past a set age, cross aged accounts where a large share of a customer's balance is past due, amounts owed by affiliates, foreign receivables without credit insurance, contra accounts where the borrower also owes the customer, government receivables without assignment, bill and hold sales and concentrations above a limit for any single customer. The remaining eligible receivables are multiplied by an advance rate that reflects dilution and collection risk.

Inventory is valued at the lower of cost or the net orderly liquidation value determined by an independent appraisal. Slow moving, obsolete, consigned, in transit and work in process inventory are commonly excluded or heavily discounted. The advance rate is often set as a percentage of net orderly liquidation value, which converts liquidation proceeds after costs into a lending limit. Reserves for rent at leased locations, priority claims, dilution and other risks reduce availability further. Reserves are discretionary in most agreements, which gives the lender a tool to respond to emerging risks without amending the agreement.

What do field exams and appraisals test?

A field exam is an on site review of the borrower's books and collateral reporting by the lender's examiners or a third party. Examiners reconcile the borrowing base certificate to the general ledger, test receivables through verification and cash receipts testing, analyze dilution from credits, returns and allowances, review aging accuracy, inspect inventory records and test the cash management system. The goal is to confirm that the collateral exists, is valued correctly and is reported honestly, and to calibrate eligibility criteria and advance rates to actual experience.

Inventory appraisals estimate what the inventory would bring in an orderly liquidation, net of liquidation expenses, over a defined period. Appraisers consider product categories, gross margins, seasonality, recovery for different inventory types and the cost of running a liquidation sale. Field exams and appraisals are typically performed at closing and then periodically, with frequency increasing when availability is tight or performance is weak. Findings from each exam feed directly into the borrowing base, for example by adding new ineligible categories, adjusting advance rates or imposing reserves, which makes the exam a practical risk control rather than a box checking exercise.

• Borrowing base certificate reconciliation to the general ledger
• Receivables verification and cash receipts testing
• Dilution analysis covering credits, returns and allowances
• Inventory testing, costing review and ineligible analysis
• Review of cash management and lockbox controls

How do dilution and concentrations affect advance rates?

Dilution measures the share of invoiced receivables that is never collected in cash because of credit memos, returns, discounts, allowances and write offs. It is the single most important input for receivable advance rates. A business with very low dilution and creditworthy customers can support a high advance rate, while one with high or volatile dilution needs a lower rate or a dilution reserve. A common rule is that the advance rate should leave a margin above historical dilution so that collections would still cover the advance after credits and returns.

Concentration limits address the risk that a single customer failing or disputing invoices could eliminate a large part of the collateral. Lenders cap the eligible balance from any one customer at a percentage of total receivables, with higher limits for investment grade obligors. These limits protect the borrowing base, but they can also reveal broader business risk that belongs in the credit memo. A customer that represents a large share of receivables also represents a large share of revenue, and its loss would affect both collateral and cash flow at the same time, compounding the lender's exposure.

Why do cash dominion and reporting matter?

Cash control is the mechanism that makes asset-based lending work. Customer payments flow into a lockbox or deposit account subject to a control agreement in favor of the lender. Under full cash dominion, collections are swept daily to pay down the revolver, and the borrower re-borrows against the borrowing base. Under springing dominion, the sweep starts only if availability drops below a threshold or a default occurs. Either way, the lender can see the cash and control it when needed.

Reporting frequency scales with risk. A healthy borrower might deliver monthly borrowing base certificates, agings and inventory reports, while a stressed borrower may report weekly or even daily. Lenders monitor trends such as rising days sales outstanding, growing ineligibles, falling inventory turnover and increasing dilution, which often signal problems before the income statement does. Many asset-based lenders also stress availability under a scenario in which sales fall sharply and inventory builds, because that combination can reduce eligible collateral while the borrower's cash needs rise.

How should an underwriter evaluate an asset-based loan?

An asset-based underwriter asks whether the collateral would repay the loan in a liquidation, whether the borrower's reporting can be trusted, and whether the business can survive long enough to avoid liquidation. That means reviewing the field exam findings, the appraisal and the historical relationship between availability and usage. Excess availability, the gap between the borrowing base and outstanding loans, is the main measure of liquidity cushion. The underwriter also studies the fixed charge coverage ratio, the effect of seasonality on availability, and the quality of management's working capital forecasting. Strong collateral with poor reporting is a weak credit, because the lender cannot trust the borrowing base it is lending against.

Calculating availability under an asset-based revolver

1. Gross receivables are $10,000,000. Ineligibles include $1,200,000 over 90 days, $300,000 cross aged, $200,000 contra and $500,000 foreign, totaling $2,200,000. Eligible receivables = $10,000,000 - $2,200,000 = $7,800,000. At an 85% advance rate, AR availability = $6,630,000.
2. Inventory at cost is $8,000,000, with $1,500,000 ineligible, leaving $6,500,000 eligible. Net orderly liquidation value is 60% of cost, or $3,900,000, and the advance rate is 85% of NOLV, so inventory availability = $3,315,000.
3. Gross borrowing base = $6,630,000 + $3,315,000 = $9,945,000. Less a $400,000 rent reserve, the borrowing base = $9,545,000.
4. The commitment is $12,000,000, so the lesser of commitment and borrowing base is $9,545,000. With $7,000,000 outstanding, excess availability = $9,545,000 - $7,000,000 = $2,545,000.
5. If a springing fixed charge test applies when availability falls below 12.5% of the commitment, the trigger is $12,000,000 x 12.5% = $1,500,000. Current availability exceeds the trigger by $1,045,000.

How underwriters apply this

• Tie receivable advance rates to measured dilution with a margin for volatility.
• Lend against inventory at net orderly liquidation value from an independent appraisal, not cost.
• Reconcile the borrowing base to the general ledger and verify receivables in field exams.
• Monitor excess availability as the primary liquidity measure and model it through seasonal peaks.
• Confirm deposit account control agreements and the trigger for springing cash dominion.
• Increase reporting and field exam frequency when availability tightens or trends weaken.

Frequently asked questions

Keep reading

Educational content written by practitioners. Not investment, accounting, legal or tax advice.