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What lenders may get wrong in structuring loans

Jun 09, 2022

Although loan structuring is a fundamental aspect of lending, it’s often misunderstood.

The industry’s over-use of the term “working capital” is a major culprit in this confusion and has proven a disservice to both borrowers and lenders. This problem is compounded by the fact that “working capital” has a specific definition for accounting purposes, which does not always align with the lender’s definition.

Rather than including “working capital” on loan presentations or approvals, lenders should focus on the specific cash-flow need of the borrower, and specifically state the purpose of the loans. For instance, is a line of credit needed to fund growth? Is the borrower a manufacturer that had a mismatch in its working capital cycle? 

If so, the cash-flow need should be specified such as “fund accounts receivable” or “fund inventory purchases” or “fund input costs for crops.” Before a loan can be properly structured, the lender must first understand the specific business of the borrower and how its operating/cash flow cycle works.

Industry type matters

The type of industry a borrower is involved in will often determine the most appropriate loan structure. These five industry categories, and each specific company within it, has unique financing needs. Here’s a summary of the typical operating cycle for each industry:

Manufacturing

  1. Purchase raw material
  2. Manufacture inventory
  3. Sell inventory creating accounts receivable
  4. Collect accounts receivable to cash

Wholesale         

  1. Purchase inventory
  2. Sell inventory creating accounts receivable
  3. Collect accounts receivable to cash

Retail

  1. Purchase inventory
  2. Sell inventory for cash

Service

  1. Perform service
  2. Receive cash or collect accounts receivable

Agriculture

  1. Purchase raw material
  2. Grow/manufacture inventory
  3. Sell inventory
  4. Receive cash or collect accounts receivable

Once the lender understands the basic operating cycle of the borrower, it may have to dive further into the details depending on the complexity. For instance, if the borrower offers payment terms to its customers, what are the specific terms offered? What terms are the borrower offered by its suppliers for inventory purchased? Only after the full operating cycle of the borrower is completely understood by the lender can it begin to match the best loan structure for both parties.

Keeping the elements of these four basic loan structures in mind will help borrowers and lenders be more in tune with the appropriate reference to “working capital.”

Seasonal loans

They generally fund the purchase of inventory or cost inputs during a certain time of the year. Examples may include a mulch supplier or crop farmer. The loan proceeds are often used by the borrower to pay suppliers, the seasonal inventory/product is eventually sold, receivables may be collected, and the lender is repaid over a certain time frame, which should be clearly understood at inception.

Term loans

These are repaid from the cash flow of a business over a period longer than one year. While the purpose is often to purchase non-current assets, that is not always the case. This is probably the most common loan structure and is generally well understood within the industry.

Bridge loans

These loans are mostly seen in real estate construction to fund a cash flow gap until a specific event occurs that repays the loan. Lenders generally understand the need adequately and structure the loan appropriately.

Permanent/revolving capital

This type is where poor loan structure is most prevalent. It’s used to fund ongoing purchases of current assets or payment of current liabilities. While many financial institutions structure these loans with one-year maturities for monitoring purposes (or simply habit), the need is often long-term or indefinite in nature, and the debt can actually be a considered substitute for owner’s equity. This type of lending most often gets institutions in trouble when they don’t understand the borrower’s need or monitor the loan adequately through a borrowing base or other loan covenants.

This is where the generic term “working capital” is most often used for the loan purpose. Unless the borrower has a significant mismatch in its working capital cycle, this type of loan may only be appropriate to fund growth. Without proper understanding and controls, the lender may find out what it has really been indirectly funding is operating losses or salary/distributions to the owners to fund their lifestyle needs.

While the information appears fairly straightforward, in reality, organizations usually don’t operate with such precision. In this example, consider the borrowing needs of a crop farmer. This type of borrower typically has a fairly well-defined working capital cycle and seasonal cash flow need. However, what happens when crops harvested in one year are not actually sold until later periods? To avoid financing multiple years’ worth of harvests and potentially funding operating losses and other expenses, any carryover crops should be segregated with a new short-term loan and monitored appropriately to ensure the debt is paid through the sale of the crops as expected.

How Wipfli can help

No matter how much experience you have working with different loan products and borrowers, it makes sense to review the basics and dig deeper to understand your borrowers’ needs and avoid generic applications of “working capital.” Your credit committee and your borrowers may thank you. Wipfli professionals can help you review your lending practices to ensure you are best meeting the needs of your clients and customers.

Contact us to learn more about the guidance we provide to financial institutions.

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Author(s)

Daniel Zigler, CRC
Senior Specialist, Loan Review
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