Financing Consumer Paper with a Commercial Loan
As credit cards become more and more common, most retailers have moved away from offering in-house financing to their customers. While in the past it was common to have store credit cards, most of those offerings have been replaced by “branded” credit cards in the case of national retailers or disappeared altogether in the case of small and regional retailers.
However, there are some types of retailers where providing financing is still important in order to compete. Furniture and Appliance retailers come to mind. The availability of easy and affordable financing is a strong lure for the consumer looking to make a big purchase. The ability to dangle the instant gratification of enjoying an expensive item while telling the customer that they don’t have to worry about payments for many months is a great selling tool.
What does this have to do with Commercial Lending?
The answer is easy. Any company that provides in-house financing to retail customers will face a need for financing in order to carry those receivables. If the in-house financing program is successful and most of the sales are self-financed, the company could find itself carrying receivables in excess of annual sales easily.
Let’s say for instance that I sell dining tables, and I give my customers three-year amortization terms with six months of no payments upfront. A company like that could find itself carrying a couple of years’ worth of sales as receivables in the balance sheet. The dining table manufacturers would be unlikely to wait 38 months to get paid in full. The company would certainly approach a lender to help them carry those receivables.
If you are a bank underwriter, you are probably unconcerned about this financing request. After all, your employer provides working capital loans specifically receivable financing all of the time. Why would this be any different? Maybe, I can shed a light on this subject having participated in the underwriting of two lines of credits that provided financing for consumer paper in my banking career.
Short-term business credit is different than long-term consumer credit. In a normal business to business relationship, selling terms are usually between 30 days and 90 days. The short-term exposure lowers the risk to the seller, and transactions are usually frequent enough for the seller to spot any deteriorating patterns. Consumer credit on the other hand is more of a single transaction experience. After all, there are only so many times a consumer will buy a dining table.
Underwriting criteria might be compromised for the sake of sales. The primary business of the company is to make sales, and the temptation to make the sale might be enough to compromise the underwriting guidelines. If the company is running a special whose selling point is “nobody gets turned down for financing”, one can only imagine the risk profile of that portfolio.
This does not mean that only small companies are guilty of this. I remember talking to a friend that worked for Nortel, who told me one of the reasons why that company ended up having a liquidity crunch and failing was that Nortel got into the habit of providing long-term financing for projects all over the world that were marginal as far as credit was concerned so that sales would continue.
Consumer paper usually has a higher level of dilution. The percentage of receivables that are not collected is higher for long-term consumer receivables.
Does this mean that commercial lenders should shy away from this type of lending?
Not necessarily, all this means is that the fact that we are talking about financing a different type of asset needs to be recognized and the proper structure needs to be in place. Some of the items that we make sure are incorporated in the underwriting of these facilities are:
- Understanding of the borrower’s underwriting criteria. The lender needs to be comfortable with it and its implementation. Testing it against the receivable pool might be a good idea.
- Adjusting the advance rates downward to take into consideration higher dilution.
You can get additional information on this subject by buying the following books from Amazon: Essentials of Working Capital Management
or Get Financing Now: How to Navigate Through Bankers…..