What is “Collateral”?
Collateral is an asset of some sort that a borrower pledges as a guarantee of repayment of a debt or loan. Should the borrower default on the agreed repayments, the lender would have the right to take possession of the pledged asset, known as collateral. The size of the collateral required for the loan usually depends on the ability of the borrower to repay its debts, and also the size of the loan required. The collateral will act as security for the lender to ensure it will be repaid the loan amount.
A simple example of collateral is a mortgage, whereby the underlying house or apartment is used as collateral. If the borrower is unable to meet its mortgage repayment obligations, the lender will (according to the specific mortgage contract) have the right to take possession of the house, usually regardless of the proportion of the debt already repaid. It is rare that a borrower will want to forfeit the collateral on a loan, so will usually do their best to ensure the repayments are kept on schedule and as planned.
It is worth noting that not all debt financing requires collateral. Unsecured loans do not require collateral. These are usually only issued to highly solvent entities such as highly wealthy individuals and multinational organizations.
There are three generally accepted sources of debt repayment in business lending: cash flow from operations, collateral value, and personal/business guarantees. A lenders’ preference is most typically to have repayment from the cash flow. If this is not possible, the lenders will seek to recoup the loan by selling the collateral. Finally, if the proceeds from the collateral sale are insufficient, then personal or other business guarantees may be used to plug the remaining amount.
It is important to note that banks and other lending institutions’ strong preferences are to be paid back from the cash flow from operations. Seizing and selling assets is problematic and costly for lenders.
Key Learning Points
- Collateral is an asset pledged by a borrower to guarantee repayment of a debt and reduce the overall risk for the lender
- If the borrower defaults on loan payments, the lender can seize the collateral and sell it
- Many different assets can be used as collateral, and the choice of collateral usually depends on the type of loan
Types and Examples of Collateral
Almost anything of value can potentially be pledged as collateral. The following are the five most common types of collateral seen in the business world:
- Consumer goods: items that have been purchased by the business or consumer, e.g. a car
- Equipment: machines, vehicles, etc. used in business or government operations
- Farm products: crops or livestock
- Inventory: finished goods, work in progress or raw materials
- Financial assets: stocks, bonds, and cash balance accounts
Lenders conduct collateral analysis to determine the market value of a company’s assets, which can be difficult to observe directly. A collateral analysis is more important for less creditworthy borrowers. The following four issues are commonly considered when assessing collateral values:
- Intangible assets: high-quality intangible assets are generally assets that can be quickly sold for cash. An excellent example of a high-quality intangible asset is a patent. Goodwill is a low-quality intangible asset usually written down when a company underperforms.
- Depreciation: depreciation schedules and capital expenditure analysis indicate the age and quality of the company’s assets. Poor asset quality may lead to reduced future operating cash flows. Older assets are usually harder to liquidate and, therefore, not high-quality collateral.
- Equity markets capitalization: when the stock of a company trades below the book value, this could indicate poor asset quality.
- Human and intellectual capital: although tricky, it is possible to value intellectual property and use it as collateral.
MCQ on Collateral