Adding Basel to the Debt Mix
No it isn’t a typo. Basel refers to the banking accord addressing financial risk in lending that will be mandated for many banks (and their customers) in 2007. Basel II requires certain banks to begin setting aside capital against short-term loans (lines of credit) and applying credit risk calculations for lending.
The capital set aside requirement essentially will increase the cost of these loans for banks. As a consequence, line of credit users (you, for example) should expect these costs to be passed on to them ultimately. For small and mid-size companies, this means that these “low cost” financing alternatives may be priced to reflect risk.
Risk calculation equations for companies without a formal credit rating have been recommended for banks to use when evaluating risk of default. For many businesses the combination of assessed default risk and the additional requirement for the banks to hold capital reserves for risk will undoubtedly lead to higher interest rates. While large banks will be the first to implement and the initial implementation will focus on larger companies, it is only a matter of time until all banks and the majority (if not all) companies will fall under the umbrella of Basel II practices.
Companies dealing with the larger, internationally active banks will feel the impact first because, by agreement between international banking entities, implementation of Basel II is mandatory for these banks. These banks will be required to apply more precise calculations to the probability of default. This probability of default calculation is called the Advanced Internal Ratings Based approach or A-IRB. The A-IRB will be applied by banks when pricing loans to companies, including lines of credit (loans of less than 364 days). The bank will then determine the capital reserve amount that is appropriate for the loan risk based upon other accord requirements. All of this means increased costs of the loan to the bank, which inevitably means increased prices (interest) for your business.
If your business is heavily dependent on your line of credit, 2007 is just around the corner! It is time to begin evaluating your alternatives. Whether you are a large corporation or a small business, if you count on your line of credit as an expensive form of borrowing, it is time to plan your cash management strategy.
As the cost of borrowing increases, so does the pressure to improve your internal operations and cash conversion cycle – the time from acquiring the components of what you sell, whether it is materials or labor or both, to the time you have cash in hand from the sale of your product or service. Credit terms from your vendors play an increasingly important role in leveraging your business. The better your vendor terms, the more time you have to make the sale and collect the cash from your customer before you have to pay the vendor.
On the flip side, the terms you extend to your customers impacts how will quickly you are able to collect cash. The risk associated with extending credit and the credit limits for each customer must be managed even more closely.
If your business is selling products, finding the right inventory levels, reorder points, and managing all aspects of your inventory will have an increasing favorable impact in your businesses need to borrow. The right investment level in inventory combined with favorable vendor and customer credit terms will reduce the need to seek cash through your line of credit.
The impact of better internal financial controls and managerial oversight leads to less dependency on a day-to-day basis on the credit line. In turn, this improved performance translates into reduced risk and better lending terms.
Now is the time to develop a strategy to decrease your reliance on short-term loans/lines of credit. The improved financial management and operations will be reflected in both your risk rating (interest rates for borrowing) and in the performance of your business.
Here are several recommended actions:
• Review your cash conversion cycle including vendor and customer credit terms
• Analyze inventory levels and management policies to see if there are opportunities to reduce levels
• Analyze your business line (by product or service) to understand where your profits are
• Determine if there are opportunities to improve collection procedures for accounts receivable
• Analyze production processes to decrease quality issues – scrap and rejects
Reducing dependency on external lines of credit means improving the ability of your organization to generate and manage cash from operations. Now is the time to begin, before you know it 2007 will be here.
Copyright ©2005 F.O.C.U.S. Resource, Inc.