Advance Rate: a Worked Example

A financier lends against collateral that will be turned into cash later, by someone else if things go badly. Each step between the asset and the cash can lose value, and the rate is set so that those losses fall on the borrower's share first. The owner, for its part, still has something to lose if the collateral disappoints, and a reason to collect its debts and sell its stock at a fair price.

Collateral that converts more quickly and with more certainty is advanced at a higher rate. Receivables are usually funded more generously than stock, because a debt is a fixed sum due on a date and stock still has to be sold. The US national-bank supervisor's handbook states the principle for all collateral types: the rate should reflect quality and liquidity, with weaker assets advanced less. Stock is commonly advanced against an appraiser's net orderly liquidation value, or against the lower of a percentage of cost and a percentage of that value, because cost says little about what a forced sale would bring.

On a single financed invoice the mechanics are plain. At an 80% rate, a US$100,000 invoice produces US$80,000 when it is financed, and the remaining US$20,000, less the financier's charges, is released when the customer pays. Under a borrowing base, and on many whole-ledger invoice finance facilities, individual invoices are not tracked that way; the rate applies to the whole eligible pool at each reporting date.

Three things sit beside the rate, and a quoted number says little without them. The definition of eligible receivables decides what it applies to, so a high rate on a narrow pool can fund less than a lower rate on a wide one. Reserves take a further amount off the result. And some agreements let the lender change the rate or add reserves after a field exam. The effective rate on the gross ledger is the figure that allows two offers to be compared.

A distributor of commercial vehicle batteries, constructed for this page like every figure in it, has a ledger of US$7.0m, of which US$5.0m is eligible, and asks for a 95% advance. The financier first estimates what the eligible ledger would yield if it had to be collected after the distributor stopped trading. The estimates and rates are the example's and are not a market norm. In US$m:

A rate above 87% leaves the financier relying on something other than the ledger. At the 80% the financier offers, the cushion is US$350,000, which exists because the estimates could be wrong and a failure tends to make all three worse. The effective rate is lower again: US$4.0m on a US$7.0m ledger is 57%.

The US$750,000 between the 95% requested and the 80% offered is worth reading closely. If the business needs that sum whatever the state of its ledger, the shortage is of longer-term capital, and the file is better served by asking whether the need is temporary or permanent than by adjusting the percentage.

The two look alike and work differently. A loan to value ratio is a result: the loan divided by a valuation at a date, usually on a single property. A maximum LVR can be written in as a covenant, but the loan stays where it is until someone acts on a breach. An advance rate is a term of the contract, applied each period to a changing pool, and the amount that can be drawn follows it up and down without anyone having to call anything.

A haircut is the same idea seen from the other side: an 80% advance is a 20% haircut. One phrase uses the same words for something else. A New Zealand dairy company's advance rate schedule is the timetable on which it pays farmers for milk, and no collateral is involved.

DEFINED IN ONE PARAGRAPH → · WHAT IT APPLIES TO → · INVOICE FINANCE →

The advance rate is where a credit assessment of a ledger reaches the borrower as an amount of money. A small change moves availability every period for the life of the facility, so it deserves as much attention as the margin. In Issue 02, the senior read caps a US dollar sub-limit at 80% of eligible US dollar receivables, the same idea applied to a single currency, and there the unfinanced share has to absorb a move in the exchange rate as well as disputes.

Rates can also differ inside one facility, tiered by how quickly each kind of collateral would convert, and can fall when the evidence worsens. Trade loans and pre-shipment finance apply the same logic to a purchase or an order, where the collateral is not yet a debt and the rate has to allow for the chance the goods do not ship. In each case the reader asks the same thing: what does this share of the asset have to survive?