Borrowing Base

How Does the Borrowing Base Work in Lending

The borrowing base in an asset-based lending agreement is intended to ease the credit risk burden undertaken by a lender, as part of contributing financing to a specific borrower.

Since the borrower pledged collateral to obtain the debt capital needed, the lender has the right to seize the collateral in the event of default. But of course, the entire ordeal of the borrower filing for bankruptcy in Court could easily complicate matters (and become a drawn-out process).

The term “borrowing base” is most often about a revolving credit line (or “revolver”), which is akin to a corporate credit card, or an asset-backed loan (ABL).

The revolver can be drawn from and paid down on an ad hoc basis—i.e. on a need basis—however, there is an upper parameter set to restrict the borrowing capacity (i.e. “ceiling”).

Therefore, the borrowing base is comparable to placing a “cap” on the credit facility, and the maximum amount that could be drawn from the credit line is a function of the borrower’s liquid collateral.

From the perspective of the lender, the two most common current assets widely accepted as collateral are inventory and accounts receivable (A/R).

Why? The inventory and receivables of a company are marketable and can be easily converted into cash in the open markets, without the necessity of attaching a steep discount. In contrast, fixed assets (PP&E) would require a considerable amount of time, including a hefty discount.

What is the Borrowing Base Certificate?

The borrowing base certificate is a formal document that highlights the relevant terms and provisions regarding the collateral, namely the method by which the borrowing base will be re-calculated.

If the collateral fluctuates in value across the term of the financing, the borrowing base also changes in tandem. Hence, the lending document is critical to both parties in the transaction because the agreed-upon terms dictate the borrowing base availability (or deficit).

• Surplus ➝ If there is sufficient availability, the borrower can draw down on the credit facility.
• Deficit ➝ If there is a deficit, the borrower will need to inject cash, or perhaps replace existing assets with higher-value assets to pay down the debt obligation.

How to Calculate Borrowing Base

The calculation of the borrowing base is contingent on the specific terms laid out in the lender agreement between the lender and borrower.

In short, the size of the borrowing base (and the amount of capital to draw on) is directly tied to the value of the collateral that the borrower pledged.

While the process of quantifying the borrowing base is specific to each borrowing, the following steps offer a general overview:

1. Identify Eligible Assets ➝ The current assets (e.g. accounts receivable, inventory) deemed eligible for inclusion in the borrowing base are tracked, which is based on the criteria set by the lender.
2. Estimate Fair Value of Eligible Assets ➝ The eligible assets have ascribed a value in an independent appraisal based on their classification (e.g. accounts receivable aging, the market value of the inventory)
3. Apply Advance Rates ➝ The value of the eligible assets must be multiplied by their respective advance rates, which are percentages that reflect the lender’s assessment of the collateral quality (and liquidity risk).
4. Calculate Sum of Adjusted Values ➝ The value of the collateral post-adjustment is equal to the total borrowing base for the credit facility.

Borrowing Base Formula

The formula to calculate the borrowing base is the sum of the collateral pledged by the borrower once adjusted downward by the advance rate.

For instance, the advance rate could be 80% for accounts receivable, and 60% for inventory.

Usually, the borrowing base is a percentage of the value of the borrower’s eligible collateral, with the selected percentage dependent on the quality and liquidity of the accounts receivable and/or inventory.

The borrowing base is updated periodically—e.g., monthly or quarterly—to protect the lender’s downside risk and ensure there are no material changes in the collateral value (and ensure the credit line extended aligns with the current value of the assets).

Note: Certain lending agreements will contain a provision termed “concentration limits” to provide further diversification in the risk.

Borrowing Base Calculation Example

Suppose an asset-based lender is tasked with measuring the size of the borrowing base for a particular financing arrangement based on the collateral pledged by a corporate borrower.

The corporate borrower has $10 million in accounts receivable (A/R) outstanding on its balance sheet, along with $20 million in inventory.

The lender analyzes the quality of the collateral and the surrounding context before determining the appropriate advance rate is 85% and 60% for the accounts receivable (A/R) and inventory, respectively.

• Accounts Receivable (A/R) = $10 million (with 85% Advance Rate)
• Inventory = $20 million (with 60% Advance Rate)

Since the lender has the necessary metrics on hand, the borrowing base attributable to the financing can be computed.

• Borrowing Base = ($10 million × 85%) + ($20 million × 60%) = $20.5 million