In this lesson, we're going to take a wide pass at all the different sorts of secured lending arrangements. Now debt is very common in the capital structures of most companies. most mature companies have some sort of operating line with their bank, regardless of whether they regularly use it or not. major capital expenditures are often difficult to fund up front and many companies will seek some sort of financing arrangements to pay for this investment over time. The lenders now have access to security in the form of tangible assets. And this minimizes their risk and consequently makes borrowing against these sorts of assets very affordable for companies.

Many of you are familiar with an operating line of credit, whether that's for your business or your personal situation. It works the same way. You draw on it when you need it, and you pay it back when you have excess cash on hand. And asset based lending facility works similarly to an operating line of credit, but it has a few fundamental differences which we'll look at in a moment. In the next column, you're going to have all sorts of different types of term debt. And this covers everything from equipment loans to building mortgages to secure bonds.

And lastly, we have leasing and often forgotten form of financing because you don't actually take title to the asset acquired, but it's an important form of financing and offers advantages that you won't get with any other types of debt. Now, keep in mind are dimensions of capital that we raised in our opening lesson. As we compare and contrast the different types and sorts of debt facilities. Let's first look at the merchant or the advanced rate. This determines the amount of financing you can expect Operating lines are often secured by working capital, like receivables, and inventory, and the bank isn't going to give you $1. For dollar financing of these types of assets.

You can expect margin rates of up to say 90% for receivables and perhaps as much as say 75% of finished goods inventory. However, there's often an upper limit that may be less than this stated facility maximum. For example, I've seen a number of facilities that can get constrained by a limit on the multiple or the coverage of eba earnings before interest, taxes, depreciation and amortization. And so in the row below this, we note that that basis for determining the margin amounts that are typically based on your your gap basis accounting values. Now let's compare this to an asset based lending facility. And this abl looks very similar but there's a few points distinction I want to I want to make an abl facility is is highly dependent on the security provided.

Whereas under a line of credit security while important is equally important to the profitability of the organization. Notice that the basis of the abl advanced is the liquidation value of the security, which is not necessarily the same thing as the book value which may be higher or lower than the gap value. Now, the abl facilities may be structured to take take in other assets such as equipment and other long term tangible assets. Now as we move over a call to the term debt, this one is different because there's typically only going to be one draw, and then the balance gets repaid according to some schedule of repayment and maybe a straight principal repayment or a blended payment of interest and principle, or the amount may have a amount due at the end of the loan, the amount of term debt typically has similar sorts of constraints as well.

The ratio of debt to the value of the security is called the loan to value ratio or the LTV ratio. So for instance, real estate is commonly one of those sectors that uses this LTV terminology. residential properties, like apartment buildings can often finance up to 80% of their LTV. commercial properties might be a little less a 65% of LTV, hotels, or even less than that 50% of LTV. And then the final column we have leasing. One of the biggest advantages of leasing is that you get 100% financing of the value of the asset to which you want to acquire.

Now obviously, you can't lease receivables or you can't lease inventory. But if you're looking to acquire a piece of equipment or a specialized facility leasing offers this important advantage. Next, let's talk about the terms of each of these debt facilities. Operating lines and abl lines are typically renewed annually. Short term facilities have two primary risks that you need to consider. The first one is renewal risk.

And the second one is interest rate risk, as these are almost always on a floating rate basis. To the right of that we have term debt, which is typically used to finance capital assets. And does it make sense for it to be repaid over a longer period of time. Now, don't confuse the term and the amortization period. You can add, say a building mortgage that has a repayment based on a 25 year amortization schedule, but the term of the facility may be only for say five years, which simply means that you have that renewal risk in five years time when you need to refinance the remaining balance at that time now leasing terms are flexible and situation specific. If you're renting space at the mall, the lease term may be for a couple of years after which you have no residual obligations.

However, if you're leasing a specialized facility or piece of equipment, the term of the lease may be for the economic life of the asset leases used to provide some accounting advantages as well. As a result, lease leases were structured in ways such that the obligation would not show in the liability section of the balance sheet of your company. However, emerging changes in gap in recent years are pretty much eliminating this ability to treat leases as an off balance sheet liability. And so really, it's coming down to an economic decision on which is the cheaper source of financing. Let's move down and start talking about the cost of financing and what many people do as they focus on the stated interest rate of the facility. However, you can never lose sight of what I'm going to refer To as the the hidden costs of financing, you need to be aware that there's issuance costs, sometimes called commitment fees, the appraisal fees of various assets and lawyer fees, which can amount to 10s of thousands of dollars, even for simple lines of credit, ongoing fees such as standby charges, administration costs, audit or review requirements, and ongoing consultants made that may also be engaged by the bank on your behalf also drive up the effective interest rate of the credit facility.

So you really need to factor in the full range of these financing costs when you compare and weigh the trade offs between each of these different sources of financing. But let's just focus on how the stated interest rates are established for each of these different facilities for your operating line of credit. These are often very affordable facilities, particularly in today's low interest rate environment. As of today, one of the companies I'm involved with is paying less than 2% on its line of credit, that's unbelievably cheap money in a historical context. Now acid base lending facilities work in a similar way to the operating line lines. But sometimes you'll see these facilities quoted using another basis of pricing called libre, libre or plus a spread lie board is the London interbank offered rate, and is a reference rate based on the interest rates at which banks borrow unsecured funds from other banks in London wholesale money markets.

Now live more is often quoted as this is the world's most heavily traded short term interest rate future and futures are often used as the basis for interest rate swaps, or to lock in or convert a fixed loan to a floating loan. So when you have these sorts of live war plus a spread, these tend to be a little bit more expensive types of have credit facilities. When you get into term debt, you may be quoted with either a flexible or floating rate. Banks tend to give you a floating rate and then offer an interest rate swap separate agreement to lock in the interest rate if you desire. other financial institutions such as, say a life insurance company, they tend to favor offering a fixed rate term sheet. Now because we are borrowing for a term, the relevant index will be comparable against government bonds have a similar term to determine what the spread is between what you're being quoted and the benchmark in the lease agreements.

The interest rate is often not even explicitly stated, or worse, the lessor may be indicating that they're providing you with zero percent zero percent financing by playing with some of the variables or the other variables in the equation, such as, say the purchase price or the guaranteed residual values in one of the bonus lessons. I'm going to Give you in this course I'm going to give you a framework for calculating that implicit financing rate. Now let's talk about some of the conditions of these debt facilities. Operating lines are monitored by your relationship manager at the bank, you may be asked to provide monthly or quarterly financials, you will also have to supply annual financials that are either audited or reviewed by a public accountant. Now the threshold between having an auditor review is approximately a million dollars. However, the cost difference between one of these can be 10s of thousands of dollars.

So obviously, you want to weigh that as well. Now your lending agreements will describe specific covenants that must be met. Common financial covenants are based on the current ratio, the debt to equity ratio, and the debt service coverage ratios. Now pay particular attention to how these are calculated, and you can negotiate these descriptions to suit your needs. And your circumstances, you've got to be proactive with your bank. There's nothing worse than surprising your lenders by violating one of these covenants.

It puts you in the the uncomfortable position of having to request a waiver from the bank. And failure to give that waiver gives the banks a lot of powers it gives them the right to call their loan and put you in a very precarious position. If you don't have alternative sources of financing, your loan may get sent to what is called the special credit department at the bank. Now these guys can be tasked with recovering as much possible of the principal bounce and may break up or dissolve your company to achieve this. The banks have a number of tiers or the watch list before you get sent here. So it's always a good idea to know where you stand with your bank.

Now let's look at the asset based lending facility which is what we typically call a covenant light lending facility. restrictive covenants that we just discussed would be limited. However for this reason, the lenders actively monitor the value of their security very closely, often on a weekly or a bi monthly basis, they may hire consultants to come in and inspect the existence and the condition of your inventory. For example, term debt facilities will have varying levels of monitoring and covenant compliance requirements. Often these are going to mirror what you would expect for your line of credit. leasing often has no monitoring or restrictive covenants to deal with.

However, keep in mind that you don't actually own the assets, which gives the less or the repossession or the eviction remedies to cure non payment. And finally, to wrap up this lesson, let's talk about the flexibility of each of these facilities to the business. Now, an operating line tends to be highly flexible, it gives you financing when you need it, and it allows you the ability to read Pay it when you have cash available. The asset based lending facility is even more flexible given that the facility is structured independent of how your business is performing. So let's look at that for a moment. All of the following are applicable applications for an abl facility.

So first if you have companies that are experiencing rapid growth, and you need to maximize the amount of capital available when profitability ratios may still be low, and abl facility can help you in this situation. Secondly, a company that is experiencing a seasonal bulge at some point throughout the year. Thirdly, a turnaround situation where there's earnings volatility that prevent the company from accessing traditional lines of debt. However, the balance sheet still offers adequate security. And finally, companies that work in cyclical industries that need more working capital flexibility and less stringent covenants. to withstand those periods of decreased sales activity.

So comparatively speaking term debt has less flexibility. You have scheduled debt repayments of principal and interest to make and you'll likely incur penalties to prepay the debt early. And if the interest rates have changed favorably than the lenders sometimes charge you the last interest income differential on the early extinguishment of this debt. lease has to have less flexibility, though there's often provisions for early buyout included in your lease agreement that few people read, always weigh the cost of buying out leases against your incremental cost of borrowing. And finally, I've made a note to mention sales leaseback financing. If you have an asset that isn't integral to your core competency.

Say you own a building in which you have your offices and you need financing. One option is to Sell that building, lease it back from the vendor to receive proceeds for reinvestment. Nothing changes operationally, only now you have a pot of money that you can reinvest into your core business activity. So let's wrap up the lesson by putting debt financing into context. debt financing is, on all likelihood going to be your cheapest source of financing after supplier credit. However, it comes with risks.

Certain types of businesses are less able to withstand higher levels of debt leverage. Businesses, which should have lower levels of debt include firms with assets that cannot be carved out and sold easily. firms with uncertain or cyclical earnings and cash flows, firms that have financially strong competitors, who may be using tactics such as predatory pricing looking to exploit downturns to improve their competitive position. And then finally, firm's with low earnings or cumulative losses who have limited abilities to utilize tax shields created by interest expense. If you're unable to meet those debt obligations, you risk losing control of your business. So we always have to bear this in mind.

That's all for this lesson, but in our next lesson, we're going to tackle mezzanine financing. Until then,