Borrowing Base Certificate (BBC): The monitoring you wish you had when a loan goes bad.

Picture this, you are a young banker, and at this point, everything is going well.  Customers businesses are doing well, your boss is pleased, and you are happy.  Then you get a notified that one of your customers is struggling and contemplating shutting down.  The first question you have, what does this mean for my loan.  Lucky for you, at origination of this customer’s line of credit, you setup a monitoring system called a Borrowing Base Certificate (BBC) to monitor the loan balance and underlying collateral.  In this case, you are in a good position to prevent a loss, but you wonder what this could have looked like if you had just given the customer a line of credit with no monitoring, and you had just sent them off until next year’s renewal?  That would have been an unwelcome surprise.  Usually what happens when a business is struggling is it slowly burns through the assets that collateralize your loan.  The customer does this by selling inventory and not restocking the shelves or by collecting a receivable and instead of using the proceeds to pay down their line of credit, they keep it in the checking account to cover payroll or other expenses.  When this happens, your collateral is slowly (and secretly) dwindling away, and many times, you don’t realize it until it is too late.  This is the scenario a BBC can protect you from.  

Here is what we are going to learn:

1. What is a Borrowing Base Certificate and when should it be used
2. How is a Borrowing Base Certificate completed
3. How do you read a BBC when you receive it
4. I have the BBC, now what

What is a Borrowing Base Certificate (BBC) and when should it be used

A Borrowing Base Certificate (BBC) is a monitoring tool where a customer periodically fills out a report identifying the Line of Credit (LOC) balance along with its corresponding collateral.  This makes a little more sense when you think about what a line of credit is typically used for by the customer.  A line of credit is normally used to finance “Current Assets,” which are things planned to be sold in the next 12 months (think of inventory and accounts receivable).  A customer will take an advance on their line of credit in order to have the cash necessary to purchase inventory.  Then the customer will sell the inventory, and most often this will create an accounts receivable if the buyer didn’t pay cash at the time of the sale.  Eventually this accounts receivable is collected, and those proceeds are used to pay down the original advance on the Line of Credit.  This process is then repeated many many times over the course of the year (psst, this cycle is called the Operating Cycle).  In this case, the line of credit balance goes up as the inventory is purchased, and it goes down as the accounts receivable are collected.  All that a BBC does is periodically check to make sure this correlation is happening.  

Below are a few reasons that may prompt a banker to consider monitoring with a BBC:

1. New Business
2. Loan type is a line of credit
3. Size of the line of credit
4. Customer has history of using LOC for other purposes in the past
5. Higher risk customer
6. Struggling affiliate businesses

How is a BBC filled out and submitted

Typically BBCs are required on a periodic basis (often monthly or bi-weekly).  At origination, the banker provides the customer with a BBC template where the borrower identifies the values of their assets such as Inventory or Accounts Receivable as well as their LOC balance as of a certain date.  The borrower will fill out this sheet, and then they will submit this report along with the corresponding Balance Sheet where the collateral values came from.  These collateral values will then have an Advance Rate applied against the value to determine how much the borrower can borrow against this collateral.  Finally, the sum total of the discounted collateral establishes the limit on how much the customer may borrower (this value could be less than the actually LOC limit) is compared to the borrower’s LOC balance to determine if there remains excess availability or if in the case of a shortfall, the borrower needs to pay down the LOC.  

How do you interpret a BBC when you receive it

There are four main areas to review when looking at a BBC:

1. Trace values to source documents
2. Upper limit
3. Surplus or Shortfall
4. Trend in utilization over time

The first thing is pretty fundamental, but let’s just do a quick double check to make sure the borrower typed their numbers correctly into the BBC template from the balance sheet.  

The whole idea of a BBC is to make sure the availability of the line of credit expands and contracts as assets are created or collected.  What a BBC does is establish the upper limit of how much of the LOC a borrower can access.  As a banker, you do not want to unintentionally extend unsecured credit, and the use of a BBC caps the amount a customer can currently borrower based on the presently available collateral.  

The next item to review is the difference between the balance on the LOC and the lesser of either the LOC limit or sum total of discounted collateral.  If there is excess availability, then that will indicate to the banker who much additional cash can be given to the customer.  If there is a shortfall, this is the amount that the borrower will be required to pay down on their LOC.

The last area to review would be the trend in percentage of utilization.  This is an area of extreme importance but is usually forgotten about.  The idea here is to look at the trend in what % of the available lendable collateral has actually been utilized over time.  Monitoring this utilization is important because it can help you identity when the LOC was improperly used or if the business is experiencing losses.

The first thing you can gleam by watching the trend in utilization is if the LOC was used for non-LOC purposes.  An example of this would be if you had a non-seasonal customer who typically has a 60% utilization, and then you suddenly see a jump to 90%.  If things are operating as normal, when the LOC balance goes up, typically there is a corresponding increase in the collateral.  If there isn’t, it means LOC funds could have been used for a different purpose.  Examples of this could be: purchase equipment, payoff small term loan, or an owner taking a distribution.  These things are not specifically bad things, but if this use causes the borrower to run tight on operating funds, financing these activities a different way would probably be good (term loan?).

The next thing you can gleam by watching the trend in utilization is it can give you an idea of whether or not the business is operating profitably.  If a business is profitable, the first place additional profits show up is in additional working capital, and conversely, if a business is not profitable, the first place these losses shows up is a reduction in working capital.  Knowing this, if we monitor % Utilization over time, then we can spot changes in profitability early, and this can be a very good thing for you as the banker, because if you can point out these trends early, you have many more options (and time) to fix the problem whereas if the availability in the LOC is already maxed out, your options are greatly reduced.  

I have the BBC, now what?

At this point, you have received the BBC, and you have reviewed it.  Now what?  Well, now is when the BBC impacts how the customer uses their LOC going forward.  The whole idea of a BBC is that it sets the upward limit on how much of their LOC is available to be used.  If the borrower must contact their banker to make an advance on their LOC, the result of the BBC will dictate how high you can go.  If their BBC says their limit should be $600,000 even though the LOC has a max commitment of $1,000,000, the most the borrower can borrow is $600,000 until the next BBC is submitted.  In the case where the borrower needs access to more funds, the borrower can simply prepare an updated BBC to (hopefully) show additional availability.  If the borrower has online access to make LOC advances on their own, the banker should update your core system to ensure the maximum amount the borrower has access to matches what the BBC says.  

Once the borrower’s availability has been updated, the next thing you need to do is update your tracking system to remind you to receive the updated BBC at the next interval.  

Conclusion

To this point, a BBC sure seems like a benefit to the bank and a burden to a customer, and yea you wouldn’t be wrong.  If the borrower doesn’t fully understand what this document aims to accomplish, then they cannot receive the benefits it provides.  If a borrower tracks their % of Utilization, they are able to see if they are on an unsustainable path even if they don’t produce periodic Income Statements, and believe me, many small businesses do not complete regular financial reporting.  If you take the time at origination to explain the reasons and benefits for the BBC, not only will it lead to better reporting for the bank, but it can also result in a better performing business as well.