Collateral
A fourth consideration when assessing credit risk is the availability and value of collateral for a loan. If a company’s cash flows are insufficient to pay interest and repay the principal when due, the lender has the right to take possession of any collateral pledged in support of the loan. The following are commonly collateralized assets: marketable securities; accounts receivable; inventories; property, plant, and equipment; and intangibles
Marketable Securities
Marketable equity securities representing less than a 20% ownership appear on the balance sheet at market value. You can assess whether the market value of securities pledged as collateral exceeds the unpaid balance of a loan. Marketable securities representing 20% or more of another entity generally appear on the balance sheet using the equity method (See Chapter 8). Determining whether the market value of such securities adequately covers the unpaid balance of a loan is more difficult
Accounts Receivable
A lender should assess whether the current value of accounts receivable is sufficient to cover the unpaid portion of a loan collateralized by accounts receivable. Determining whether the book value of accounts receivable accurately reflects their market value involves an examination of changes in the provision for uncollectible accounts relative to sales, the balance in allowance for uncollectible accounts relative to gross accounts receivable, the amount of accounts written off as uncollectible relative to gross accounts receivable, and the number of days accounts receivable are outstanding
Inventories
Inventory represents valuable collateral to a lender only if it is salable for sufficient cash flows in the event of the borrower’s distress. You should examine changes in the inventory turnover ratio; in the cost of goods sold to sales percentage; and in the mix of raw materials, work-in-process, and finished goods inventories to identify possible inventory obsolescence problems
Property, Plant, and Equipment
Firms often pledge fixed assets as collateral for long-term borrowing. Determining the market values of such assets is difficult using reported financial statement information because of the use of acquisition cost valuations. Market values of unique firm-specificassets are particularly difficult to ascertain. Clues indicating market value declines include restructuring charges, asset impairment charges, and recent sales of such assets at a loss.
Intangibles
Intangibles such as brands, customer lists, and other assets generally do not serve well as collateral for borrowing because lenders cannot easily repossess the intangible (that is, sever it from all other assets or capabilities of the firm) in the event of a loan default. However, in some limited situations, intangibles can serve as collateral for borrowing. For example, rights owned by airlines to landing and gate slots at airports can be transferred to lenders in the event of loan default and resold to cover unpaid balances on a loan.
A fourth consideration when assessing credit risk is the availability and value of collateral for a loan. If a company’s cash flows are insufficient to pay interest and repay the principal when due, the lender has the right to take possession of any collateral pledged in support of the loan. The following are commonly collateralized assets: marketable securities; accounts receivable; inventories; property, plant, and equipment; and intangibles
Marketable Securities
Marketable equity securities representing less than a 20% ownership appear on the balance sheet at market value. You can assess whether the market value of securities pledged as collateral exceeds the unpaid balance of a loan. Marketable securities representing 20% or more of another entity generally appear on the balance sheet using the equity method (See Chapter 8). Determining whether the market value of such securities adequately covers the unpaid balance of a loan is more difficult
Accounts Receivable
A lender should assess whether the current value of accounts receivable is sufficient to cover the unpaid portion of a loan collateralized by accounts receivable. Determining whether the book value of accounts receivable accurately reflects their market value involves an examination of changes in the provision for uncollectible accounts relative to sales, the balance in allowance for uncollectible accounts relative to gross accounts receivable, the amount of accounts written off as uncollectible relative to gross accounts receivable, and the number of days accounts receivable are outstanding
Inventories
Inventory represents valuable collateral to a lender only if it is salable for sufficient cash flows in the event of the borrower’s distress. You should examine changes in the inventory turnover ratio; in the cost of goods sold to sales percentage; and in the mix of raw materials, work-in-process, and finished goods inventories to identify possible inventory obsolescence problems
Property, Plant, and Equipment
Firms often pledge fixed assets as collateral for long-term borrowing. Determining the market values of such assets is difficult using reported financial statement information because of the use of acquisition cost valuations. Market values of unique firm-specificassets are particularly difficult to ascertain. Clues indicating market value declines include restructuring charges, asset impairment charges, and recent sales of such assets at a loss.
Intangibles
Intangibles such as brands, customer lists, and other assets generally do not serve well as collateral for borrowing because lenders cannot easily repossess the intangible (that is, sever it from all other assets or capabilities of the firm) in the event of a loan default. However, in some limited situations, intangibles can serve as collateral for borrowing. For example, rights owned by airlines to landing and gate slots at airports can be transferred to lenders in the event of loan default and resold to cover unpaid balances on a loan.
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