Collateral for Loans

Loans may be secured or unsecured. In a secured loan, the borrower pledges certain assets as collateral (security) to protect the lender in case of default on the loan or failure of the business. If the business defaults on the loan through failure to meet interest obligations or principal repayments, the noteholder (lender) assumes ownership of the collateral. If the business fails, the noteholder claims ownership of those specific assets pledged as collateral before the claims of other creditors are settled.

Secured Loans
In long-term borrowing, fixed assets such as real estate or equipment are usually pledged as collateral. For short-term borrowing, inventories or accounts receivable are the usual collateral.

Inventory financing is most commonly used in automobile and appliance retailing. As each unit is purchased by the retailer, the manufacturer is paid by the lender. The lender is repaid by the retailer when the unit is sold. Interest is determined separately for each unit, based upon the actual amount originally paid by the lender and the period between the time the money is paid the lender is reimbursed by the retailer.

Accounts receivable financing falls into two categories:

Assignments -
The business pledges, or assigns its receivables as collateral for a loan.
Factoring -
The borrower sells its accounts receivable to a lender (factor).

Although these arrangements are not loans, in a pure sense, the effect is the same.

Assignments
When receivables are assigned, the amount of the loan varies according to the volume of receivables outstanding. Normally the lender will advance some specified percentage of the outstanding accounts receivable up to a specific credit limit.

For example, look at the schedule below. The company can borrow up to 80% of assigned receivables, to a maximum of $100,000.

Accounts Receivable Amount Borrowed
$100,000 $80,000
$125,000 $100,000
$150,000 $100,000

On the first line, accounts receivable are $100,000 and the amount loaned is 80% of $100,000 or $80,000. Similarly, on the second line, outstanding receivables are $125,000. The amount loaned increases to $100,000 ($125,000 X 0.80). On the third line, accounts receivable are $150,000. Eighty percent of this amount would be $120,000. However, this exceeds the established limit of $100,000. Therefore, borrowing is restricted to the $100,000 limit.

In many industries, accounts receivable financing is considered a sign of weakness. However, it is quite common in others. This is particularly true in the garment industry and in personal finance companies. When accounts receivable are assigned, the borrower is still responsible for collection. Upon collection of any receivable, the amount borrowed should be repaid. Interest is based upon the amount borrowed and the time between receipt of proceeds by the borrower and repayment.

Factoring
When accounts receivable are factored, they are sold to the factor and the borrower has no responsibility for collection. The borrower pays the factor a service charge based upon the amount of each receivable sold. In addition, the borrower pays interest for the period between the sale of the receivable and the date the customer pays the factor

Since the factor is responsible for collection, it will only purchase those receivables for which is has approved credit. When customers must pay invoices directly to a factor, it may create doubts about the company's financial stability and, therefore, its ability to deliver. However, factoring is also common in some industries. For example, high tech companies often factor receivables to finance growth and research and development. Many business look at this as a way to outsource part of their accounting activities.

Unsecured Loans
The reason that having collateral makes it easier to get a loan is that a secured creditor's risk is reduced by the claim against specific assets of the business. In default or liquidation, the secured creditor can take possession of these assets to recover any unpaid amounts due from the business. Holders of unsecured notes do not enjoy the same protection. If the company defaults on a payment, the unsecured creditor, under normal circumstances, can only re-negotiate the amount due, perhaps by seeking collateral, or force the company to liquidate. In liquidation, the holder of an unsecured note would normally have no rights that are superior to those of any other creditors.

When accepting an unsecured note, the lender will often place certain restrictions on the business. A typical restriction might be to prevent the company from incurring any debt with a prior claim on the assets of the business in the event of default or failure. For example, a term note agreement might prevent a company from financing its receivables or inventories since this would result in a prior claim against the assets of the business in liquidation. Such restrictions may have no effect on the business' ability to operate. However, in other cases, such restrictions could be severe. For example, a business may have a chance to sell to a major new customer. The new customer may insist upon 60 day credit terms which will require the business to seek additional external financing. Normally, this financing might be readily available on realistic terms from a factor. However, the restriction of the unsecured note could prevent the business from taking advantage of this opportunity.

Personal Guarantees
The liability of a corporation's shareholders is generally limited to the assets of the business. Creditors have no normal claim against the personal assets of the stockholders if the business should fail. Therefore, many lenders, when issuing credit to small corporations, seek the added protection of a personal guarantee by the owner (or owners). This protects the creditors if the business fails, since they retain a claim against the personal assets of the owners to fulfill the debt obligation.