Working Capital Lending : In the lanes of Asset Coverage

 

Under the Asset Backed Lending (ABS) environment, generally fund based and non fund working capital facilities are extended to corporates by lenders based on security of first pari passu charge on the currents assets (present & future) and second pari passu charge on the fixed assets  (present & future) of the borrower.  Although as a Working Capital (WC) lender Current Ratio is more relevant to the WC lenders, however, lenders generally monitor the building up of total assets of the borrowing company and its liabilities having charge on the assets by Asset Coverage Ratio. The ratio has more relevance when the lenders need to share charge on the assets for any new loan extended by other existing /new lender.

The existing lender generally shares the charge if the new or additional facilities (WC/capex term loan) are extended to the corporate. The reason being that the new WC facilities (subject to permitted under the MPBF) simultaneously increases current assets, and the new capex term loan facilities (permission for which from the lenders remains subject to satisfactory Debt Service Coverage Ratio and long term Debt Equity Ratio during the tenor of the new term loan) increases the fixed assets, and since the existing lender have the charge on the present and future assets, it will not decrease the asset coverage ratio (as long as the existing promoter contribution share is maintained all the time). However, if the borrower desires to share charge on the existing assets with an existing unsecured lender whose WC limits are already disbursed then generally there is a reluctance among existing charge holders in sharing the security with new lender since there would not be any improvement in assets (since the proposed lenders limits are already disbursed) and sharing of charge would result in reduction of asset coverage. However, if the existing asset coverage is substantially high then the borrower may pursue the existing charge holding lenders for sharing of charge with proposed lender. Generally for term lending, minimum fixed asset coverage of 1.50 times and for WC lending Current Ratio of 1.33 times is desired.

The WC lender generally assesses the WC requirement of a borrower on annual basis based on the audited financials for the previous year and projected financials for the next year. Let’s assume that there is only one lender with sanctioned and outstanding WC loan of USD 750 as per current audited balance sheet. Also assume that present annual WC assessment is over. Based on the assessment, MPBF worked out (based on audited financials) for previous year is USD 750, and based on the projected financials for next year the MPBF works out to USD 1000. Assume that borrower is also enjoying non fund based Letter of Credit limit of USD 100 and Bank Guarantee Limit of USD 100. Now, if the borrower proposes to bring in a new lender with WC fund based limit of USD 250 and non fund based LC limit of USD 30 and BG limit of USD 30 (assume that this proposed LC/BG requirement is within the increased assessed LC/BG limits of USD 130 each based on the projected financials), in this situation, whether the existing WC lender should share the charge on the existing securities available to him? Does he need to calculate asset coverage? What does the WC lender needs to evaluate at this point?

The existing lender should check the following points:

1. Based on current ratio principle of 1.33 times, since the projected WC fund limit requirement has been assessed to increase by USD 250, therefore accordingly there needs to be infusion of NWC/promoter contribution to the extent of 33% of the increased fund based WC which works out to USD 84. The existing WC lenders needs to ensure that these funds are infused (or there is a firm commitment as well as arrangements) by the promoters in order to maintain the current ratio at 1.33 times.

2. Of course the addition of new WC lender with required fresh infusion of NWC would maintain the Current Ratio, the sharing of residual charge on the fixed assets with the new lenders will reduce the residual FACR to the WC lender. Does it mean that no additional WC lender should be allowed unless there is increase in fixed assets? The answer to this query lies on the following two beliefs:

(A). The first school of thought believes that the primary security for WC facilities are Current Assets therefore as long as Current Ratio of 1.33 times is maintained the WC lender need not consider the residual coverage available on the fixed assets, and should share pari passu charge with the new lender.

(B). The second school of thought believes that as long as the promoter’s contribution is maintained for the proposed enhanced WC fund based limits, the WC lender should consider sharing charge with the new lender since there would be proportionate increase in Current Assets funded by new WC fund based limits and infused promoter’s contribution.

However these approaches are not favoured by the lenders who believe that such practice jeopardizes the FACR (on residual fixed assets) available to the WC lender.

 Apart from the above, some other peculiar queries are also posed while calculating the Current Asset Coverage (i.e. Total Current Assets divided by WC Capital Limits):

(i) Whether the lender should take only the sanctioned Fund Based Limit as denominator OR he should take total of sanctioned Fund Based and Non Based Limits as denominator?

(ii) Whether it is the sanctioned limit amount which is to be taken as denominator OR only the outstanding (O/s) of the fund based (OR plus outstanding of non funded limits) prevailing on the date as on which the value of Current Assets is being taken?

The first school of thought in this matter says that since during the period of stress/persistent defaults by the borrower, the borrower faces the liquidity issues and it is experienced that generally during such time, the WC FB and Non FB limits are fully utilized. In such stress time, there are high chances of default by the borrower leading to conversion of Non FB exposure into the FB exposure. Therefore, as a matter of prudent practice, the WC lender should consider the sanctioned limits (FB and NFB) as denominator while calculating the current asset coverage. This ratio should be added to the fixed asset coverage ratio (FACR) (on residual charge available to the WC lender) which is calculated based on the outstanding(O/s) term loans plus any undisbursed part, and the final Asset Coverage (i.e. total of current asset coverage ratio and FACR) should be considered by the WC lender. 

The second school of thought is this matter says that considering dynamic nature of working capital funding, the coverage should be calculated based on current data of current assets and O/s FB and Usance Letter of Credits (LCs) as long as the borrower is on the Positive List.

The current data of current assets reflects the utilized O/s FB and Usance LCs. If one takes the entire sanctioned FB limit, it may not be appropriate since the current assets available with the company are only to be extent of O/s FB and Usance LCs (plus promoter’s contribution and unsecured sundry creditors).

But what happens if the coverage is less than 1.33 times for the existing lenders? Does it mean that the short term funds have been diverted for long term purpose and therefore, the existing O/s level of current assets does not fully reflect the utilization of O/s FB and Usance LCs limits? In such cases, the lenders would need to take a separate view, away from standard logic for deciding on to share charge on the assets and based on the terms negotiated with the borrower in order to ensure suitable security for its WC limits extended to the borrower.

Non fund limits are mainly the LCs and Bank Guarantees (BGs). Outstanding (O/s) Usance LCs should be taken while calculating this coverage since the raw material under Usance LCs would have been delivered to the borrower and reflecting the current data of current assets. Under Sight LCs O/s, the related raw material would not have reached to the company therefore the current asset will be short to that extent. The Bank Guarantees (BGs) are used by the company for submission to various government departments. These BGs do not directly contribute in increasing the current assets therefore including the BG O/s in the denominator would create negative effects on the coverage ratio.

(iii) Whether one should consider the value of Current Assets and WC liabilities outstanding as per the last audited financials OR one should consider the Current Assets as given in the current available Stock Statement and outstanding/sanctioned limits prevailing on the same date?

The advantage of using the audited data is the authenticity and availability of entire current assets data. In case of using the current data of current assets generally the borrower would be able to provide only the details of raw material and receivables (details of which are also reflected in the monthly stock statement) and which is also not audited. But considering this approach being more conservative (since the lender considers only the raw material and receivables under current assets and excludes all the other heads of current assets) the lender may use the current data and also do calculation based on audited data for indicative purpose. While using the current data from the stock statement, it would be prudent to take average data of Raw Materials, Stock in Process, Finished Goods and Receivables, of 3 to 6 months depending on the conversion cycle and credit period received and provided by the borrower in its industry.

 (Disclaimer: The views expressed above are not the opinion of the author. The write up is based on the interaction of author with various related experts in the field.)