Evaluating the quality of equipment as collateral for a loan plays an important role in the credit analysis process, as it determines the potential amount of money to be paid for an asset pledged as collateral. In the event a borrower goes bankrupt, a lender can repossess the collateral and sell it off in the open market to make up for a loan loss.
The quality of equipment relates to the value of an asset pledged against a loan. It is a very important aspect of the credit analysis process.
Assets that are pledged as collateral to secure loans must be properly assessed by lenders to make sure their value can make up for a loss if the borrower defaults.
The quality of equipment can be indicated by its valuation.
Assessing the Quality of Equipment
While assessing the quality of equipment, such as machines, computers, monitors, etc., four main things should be taken into account:
What is the nature of the asset? Is there a fair market value for the asset?
Will there be potential buyers for the type of used asset, and how far are they, location-wise?
What is the useful life of the asset?
What is the asset’s condition?
Valuing the Quality of Equipment
The value of machinery and equipment determines the quality. There are four ways to assess the equipment’s value:
1. Third-party appraisal
A third party appraiser can provide an objective value for a piece of equipment, which will be accepted by both the lender and the borrower.
2. Accepted offers to purchase
Otherwise known as a purchase contract, accepted offers to purchase are documents that provide all the details necessary to value a piece of equipment. For example, a purchase contract will include the purchase price and possession date of the asset.
3. Bills of sale
Receipts or invoices related to the asset can provide an indicator of how much the machinery or equipment is worth.
4. Consulting the open market
Go to the open market and conduct a comparable market analysis to come up with a similar asset’s worth. Alternatively, we can reference the second-hand equipment market to see what a similar or identical product is worth. Auction sites are a useful resource when trying to identify the price of equipment.
Credit analysts should obtain information about any equipment or machinery that is planned to be pledged as security for a loan. Typically, items within machinery and equipment are listed on the balance sheet as part of property plant and equipment (PP&E), which is too general. Credit analysts should obtain a fixed asset register, which identifies the company’s equipment by name or type, as well as how much the equipment is worth.
Let’s look at an example below:
Above, see the fixed asset register for a company named Stampede Auto Parts.
As we can see, the total value of the property, plant, and equipment is equal to $3,225,000. The fixed asset register also breaks down the net book value for each individual item. It helps provide a general idea of the quality and value of the equipment since depreciation’s already been accounted for in the numbers.
While the report is useful, more information is required to conduct a robust analysis of Stampede’s equipment. The register lacks the information about the date of the assets’ purchase, which will otherwise give us an insight into how old the equipment is. Furthermore, the register lacks a breakdown of the assets’ gross cost and the current depreciation level, which will let us know their useful life.
So, even though we’ve obtained a register with some more details rather than just PP&E, there is still a need for more information.