Twenty years have passed since Paul Sims and I published an article in the Journal of Lending and Credit Risk Management (now the RMA Journal) entitled “The Five Keys to Depending on Accounts Receivable as a Repayment Source.” It is hard to describe the amount of change we have seen in financial services during those 20 years, and the challenges institutions have faced. While almost everything about the commercial lending process has changed since 1997, from technology to borrower/lender communication, the five keys are still just as relevant today as ever.
The five keys were meant to define the primary areas of risk management a financial institution should embrace when initiating and monitoring revolving credit transactions secured by accounts receivable. In the original article, they were defined as:
- Making a prudent initial credit decision – This key involves moving beyond the five C’s of credit to gain an understanding of the sales that are being generated by your borrower. Not all industry sectors are a good fit for accounts receivable financing. The lender must ensure that the accounts are likely to be paid in full during the anticipated billing cycle. Unique situations such as progress billings, consignment sales, and to-be-performed contracts can play havoc with a revolving line. From a credit perspective, your goal is not just to review the quality of the accounts receivable, but to study the likelihood that your borrower will continue to create quality accounts that pay in a timely and predictable fashion.
- Maintaining accurate and timely information – Technology has had more influence on this key than any other during the last two decades. The speed and availability of information has expanded opportunities for loan origination as well as risk management. Within our own ProfitStars® lineup – BusinessManager®, Factorsoft®, and Commercial Lending Management System™ – we have deployed new tools to create seamless transfers of data from the clients’ accounting system into the lending systems. These technologies create significant time savings for lenders while also offering the most accurate data possible on which to base new funding decisions.
- Ensuring control of the cash – With a true asset-based lending, or even borrowing base structure, remittance of payments from the account debtor to the financial institution is absolutely critical. This serves two purposes. It protects the financial institution by ensuring that the payments are used to pay down the line balance, and it creates new availability for the borrower to finance incoming invoices. Basically, the use of a lockbox-style payment helps both parties and enhances the financial impact of the credit facility. While the process itself has changed very little since the mid-1990s, the ability for technology to track lockbox compliance at both the borrower and account debtor levels has been a huge advance in recent years.
- Establishing effective monitoring procedures – Any system is only as strong as the lenders who are using it. Modern financial technology systems create efficiencies for lenders. More importantly, though, they create consistency across lenders and lending units within your organization. By establishing specific expectations for each credit officer, a system can not only save time, it can help with overall compliance. When we first published the Five Keys article, most day-to-day risk management functions were performed manually. Today, almost everything is automated within the process.
- Protection against changing credit circumstances – As lenders, we hope that all new loans are good, right? After all, no credit officer would ever initiate a bad loan. Bad loans evolve as circumstances change. During the last twenty years, technology has given us a new view into the process of loan evolution. By using risk factors and compliance tools to monitor loan performance, we can now prime a lender when any given loan is heading in the wrong direction. This is very important when dealing with accounts receivable, since invoices represent the fastest-moving asset on the balance sheet other than cash.
The last 20 years have certainly seen the blending of commercial credit with technology. This has created new opportunities for financial institutions. Using the Five Keys as our foundation, we have been able to create wonderful lending systems that empower credit officers to do more business in less time and with greater awareness of rising credit risk. The principals are the same, but the progress has been staggering.