Fortunately, the much-feared credit crunch for Germany’s “Mittelstand” has so far failed to materialise. German businesses tend to have good access to bank lending, even during the recent financial and Eurozone crisis. However, this comes at a cost. It is apparent that while loans for businesses are still readily available, they are becoming more expensive. Basel III requires banks to back loans with capital. The riskier a loan, the more capital needs to be allocated. This circumstance may be partly responsible for the fact that loan margins have recently been on the increase. But particularly in tough times, the “liquidity before profitability” principle still applies to businesses.

What is borrowing base financing?

Borrowing base financing is enjoying increasing popularity in Germany as a way of ensuring adequate financing for ongoing operations. This particular form of operational financing, which first emerged in the 1980s in the United States, is not entirely new to Germany. However, in view of the current economic challenges, especially for businesses with volatile inventories and a need for long-term upfront financing of supplies, it is gaining in popularity.

In borrowing base financing, the amount of credit provided is determined by the level and intrinsic value of the business’s current assets. Figuratively, the credit “breathes” in accordance with current assets. The loan limit is primarily based on the total of stock and receivables, less trade liabilities as well as liabilities to inventory holders and carriers. The current assets financed in this way simultaneously serve as security for the loan.

Advantages

Other types of security, such as land charges or guarantees, and the business’s equity ratio, play no significant role in the granting of loans. Thus, businesses receive financing that matches their maturities and is adapted to their actual resource requirements. At times of growth, the current assets that can be provided as security increase, meaning that an increased credit facility becomes available. When business is slower, however, the credit facility is reduced, which amongst other things provides companies with the advantage of lower commitment fees. Because loans made via borrowing base financing are entirely secured by current assets, banks have to back these loans with less equity capital than conventional operating loans. This leads to the loan being cheaper than other methods of financing.

In contrast to an overdraft facility, which is often only provisional in terms of duration and interest rate, in borrowing base financing the borrower has greater planning security. And unlike factoring, which typically relates only to trade debts and not to inventory, trade receivables are used as security only and not acquired by a factor. With borrowing base financing, invoicing, payment collection and dealing with late payers normally remain the responsibility of the business, meaning that personal relationships with customers are not negatively affected. The business also remains in a position to take advantage of any prompt payment discounts offered by its suppliers.

What are the potential problems?

Borrowing base financing is not equally appropriate for businesses in every industry. The level, type and value of the available security is crucial. Commodities, metals, agricultural products and chemical primary products are particularly suitable due to the ease with which they can be converted into cash in an enforcement event. Also, borrowing base financing may be more difficult for businesses that acquire their goods under reservation of title. If the supplier is not paid and thus rescinds the purchase contract with the business, the bank acquires no security interest in the delivered items. Borrowing base financing can also be problematic for businesses that store their goods in a rented warehouse, since the landlord has a right of lien over the business’s stored goods. Accordingly, these goods cannot be offered as full security to the bank. The increased administrative effort involved should not be underestimated either. Because the loan limit is determined by the business’s current assets, it is inevitable that the bank will need to be provided with updated inventory data and lists of debtors on a regular basis (every two to four weeks). Because of this administrative and documentary overhead, borrowing base financing is typically only worthwhile for loans of more than ten million euros.

Summary

Borrowing base financing is an interesting operating finance option when banks face increased capital requirements and businesses have an increased need for liquidity, particularly for German mid-sized companies. The flexibility, transparency and ability to plan cash levels, plus comparatively low financing costs, often outweigh the administrative effort involved. It is therefore likely that this method of financing will become increasingly common in Germany and emerge as an alternative to conventional operating finance.