Many businesses face a shortage of working capital due to various reasons. Such businesses can choose from multiple stress-free financing options to fund their daily business operations. Among these, asset-based lending can be a particularly effective funding option for businesses that possess a considerable amount of assets but have trouble generating cash.
What is Asset-Based Lending?
Asset-based lending is a financing avenue that allows businesses to get loans under contracts secured against their assets. Stock, receivables, equipment, machinery, and other items that belong to the company or the borrower can be used as collateral for an asset-based loan. It is crucial to note that with asset-based lending, the assets are not being sold. Businesses are merely borrowing against them instead.
As the asset is utilized as collateral for the loan, the lender has the right to seize it if the company defaults on its payment obligations. Small and medium-sized firms frequently employ asset-based lending to meet their short-term cash flow needs. However, asset-based lending caters only to businesses and not to consumers. Business owners usually turn to asset-based lending if they cannot obtain finance from a traditional lender or bank. Some loans need one asset as collateral, while others might need various assets to secure loans or business lines of credit.
Benefits of Asset Based Lending
When a company requires cash to function or expand, it can consider an asset-based loan to obtain the requisite cash if it has enough assets it can pledge. This feature makes companies turn to asset based lending for multiple reasons.
Easier to Acquire Loans Since the main prerequisite for such loans is the ownership of assets that can be leveraged, it is simpler to qualify for an asset-based financing solution. With asset-based lending, the lender is protected by the collateral used to secure the credit facility like a loan or line of credit as opposed to relying on a business’s history and projected earnings, making it easier for the borrower to acquire loans.
Utilizing Assets Effectively If a company has fixed assets on its balance sheet, it can leverage those assets as collateral to get additional working capital at competitive rates. Whether the company has invested in inventory or business equipment, those assets might be used as leverage to get money in the future for the company so that they can resolve any cash flow difficulties.
Flexibility Asset based financing solutions generally have fewer limitations on how the money can be utilized as long as it's for commercial purposes, making it an attractive alternative for businesses. The amount that can be borrowed might also increase when the value of the firm’s assets rises because it is indexed to the value of the assets.
Cheaper than Comparable Solutions Most asset-based lending schemes are more affordable than comparable options like factoring. Factoring lines are priced by deducting a percentage from the whole invoice value, as opposed to asset-based loans, which are priced using an annual percentage rate (APR).
Types of Asset-Based Lending
In asset-backed lending, a lender determines whether or not to approve a loan application based on the current and fixed assets of a company. The different types of assets used as collateral determine the different types of asset-backed loans possible:
The types of assets that can be used as the collateral includes:
- Inventory- raw resources, finished commodities, and work-in-progress are all included in inventory
- Marketable securities, assets that can be swiftly turned into cash, such as those that appear on a balance sheet.
- Land, buildings, and other tangible assets and Items like machinery, office supplies, furniture, and automobiles.
How does Asset-Based Lending Work?
The item or collection of assets used as collateral is the central focus of asset-based lending. The asset could be property owned by the borrower, merchandise for the company, real estate, or even outstanding bills. When a piece of property is pledged as security, the lender will make the borrower an offer for a loan equal to a predetermined portion of the asset's value. Because the expense of monitoring an asset-based loan is the same irrespective of the size of the money borrowed, lenders prefer to give larger loans.
Asset-based lending is usually evaluated on the basis of the loan-to-value (LTV) ratio. Loan to value is a measure of how much of the value of an asset a lender is willing to finance. Typically, a percentage is used to express the same. Assets viewed as more "desirable" as collateral typically have higher LTVs. An asset's suitability for use as collateral is often determined by the stability of its value, the ease with which the item can be transferred to other parties, and the ease with which it can be converted to cash.
For instance, the loan-to-value ratio for an asset-based loan may be stated as "the loan-to-value ratio is 80% of marketable securities." According to this condition, the lender would only be willing to offer a loan of up to 80% of the value in the market of marketable securities. Lenders are usually ready to offer a greater loan-to-value ratio for more liquid assets. The loan-to-value ratio varies depending on the type of asset. The following equation is used to determine loan-to-value:
Loan to value ratio = loan amount/asset value
Asset value is the worth of the asset that will serve as collateral to secure the loan, whereas loan amount is the amount that the lender is ready to loan out.
For certain assets, a lender provides the following loan-to-value ratios:
Trade receivables, equipment, and equity securities at LTV ratios of 70%, 40%, and 85%, respectively.
A business needs a loan for $100,000 and possesses the following things: Trade receivables worth $130,000, equity securities worth $110,000, and equipment worth $250,000.
Applying the above mentioned equation, let us figure out which asset the business will use as collateral to obtain a minimum of $100,000 loan. Trade receivables = $130,000 x 70%= $91,000 Equity securities= $110,000 x 85% = $93,500 Equipment = $250,000 x 40% = $100,000
Therefore, in order for the business to acquire the largest loan, it should utilize its equipment as collateral.
Advantages and Disadvantages of Asset-Based Lending
Asset-based lending has its own shares of advantages and disadvantages.
Timely Implementation and Financing Unlike other financing options, an asset-based loan can be requested immediately with little documentation. If the firm meets the requirements for the loan, then the request made can be accepted as soon as possible and the firm will receive the money immediately.
Interest rate An asset-based loan may have a cheaper interest rate than other unsecured loans, since the lender can seize the asset and recover any losses faced by them. In asset based lending, upto 60-70% of value of the collateral may be given to the borrower. In asset based lending there is an annual percentage rate (APR) that ranges from 7 to 15%.
Financial Stability During a financial crunch faced by the business, an asset-based loan might really assist lower the cash flow hardships and help businesses run their operations significantly. Firms can use asset based loans to improve cash flow and bring stability back to the company.
Constraints on Borrowing A firm may not be able to get as much funding as it needs because the amount they can borrow will depend on the value of the asset used as collateral and owned by the firm. The firm cannot borrow the complete amount of the value of the collateral and may receive upto 80% of the market value depending on the type of asset.
Fees With an asset-based loan, there is a possibility that the firm will also have to pay various fees in addition to the interest. Firms can expect to pay extra fees like origination fees, due diligence fees, audit fees, among others.
Assets at Risk The company's assets are possibly at risk if they are unable to repay the loan. The asset-based lender may seize or sell the firm’s assets used as collateral for the loan like machinery, inventory, equipment, or other assets.
What Types of Companies use Asset-Based Lending?
Asset-rich businesses that may experience fluctuations in cash flow yet require significant capital to run and expand are ideal candidates for ABL. Many other types of enterprises could fit that criteria.
Distribution companies are an excellent candidate for an asset backed loan. For instance, if the firm is a supplier or reseller of wine and spirits, sales will generally fluctuate seasonally. However, there can be a lag between when the firm’s suppliers are due to be paid and when the firm shifts the inventory and is able to collect from the bars, restaurants, and liquor stores it serves. The firm might also need to stock up before summer and winter holidays. Having access to a line of credit could provide businesses with the desired flexibility.
Retailers with large inventories but unstable earnings may also profit from asset backed loans. They are particularly beneficial in a situation like the recent pandemic, when a sudden nationwide closure forced clothes merchants and other businesses to close. During this period, asset-backed lending was used by some businesses to finance operations and improvements to their online presence, and compared to the other loan options from reluctant lenders, an ABL offered more liquidity and flexibility. For instance, the firms would have the freedom to use the money immediately without prior approval if they wanted to make an acquisition, form a joint venture, or declare a dividend as long as they met certain payment requirements.
Small and medium-sized businesses that are reliable and have tangible assets with value are the most prevalent asset-based borrowers. Even larger firms occasionally look for asset-based loans to meet their immediate financial demands, as it can be too expensive and time-consuming to issue more shares or bonds on the capital markets. Here, the need for funds can be urgent, as in the case of a significant acquisition or an unanticipated equipment purchase.
How is ABL different from factoring?
Accounts receivable factoring and asset-based financing are sometimes mistaken for one another. Although both are asset-based, factoring is organized differently than asset-based lending and offers the customer distinct risks, costs, and rewards. In factoring, a business sells its trade receivables to a factoring company in exchange for speedy payment in a financial transaction. Asset backed loans are a type of loan or revolving line of credit that is secured by the assets of a firm.
Time It usually just takes a few days to analyze the business' and its clients' credit ratings to the factoring company in order to receive factoring clearance. However, in asset backed loans the worth of the assets that will be utilized as collateral must be confirmed in order to be eligible for an asset-based loan. The lender may need many days or even weeks to do this.
A Different Cost Structure The percentage of the invoice value used to calculate factoring costs ranges between 1.5% and 4% for each receivable. Whereas for asset based loans the annual percentage rate (APR) is typically between 7% and 15%.
Loan and Sales Factoring is a sales transaction. No regular payments to a lender are necessary. Each time a sale is made, an invoice is factored, allowing the money from factoring to "scale up" with the expansion of your business as the firm’s receivables expand. However, unlike factoring, ABL is a loan in which a business can obtain funding by opting for a loan against its assets as collateral.
Asset-Based Lending Versus Traditional Bank Lending
Asset-based lending offers a far more adaptable method of funding a company's ongoing operations and requirements for future expansion. Asset backed loans are based on the collateral pledged for the loan, as opposed to conventional bank lending, where the borrowing firm's operations are assessed and its future cash flow is forecasted. The most common sort of ABL is one that is issued against the company's receivables. Here, the lender gives the borrowing company money depending on the value of the receivables it has received. Advance rates often fall between the range of 70 and 90 percent.
An asset-backed loan typically follows a revolving line of credit which is updated when the loans on collateral like equipment, inventory, etc are paid off. Even though asset-based lenders can lend against a variety of assets, including real estate, capital equipment, and inventory, receivables often make up the majority of the collateral for these loans due to their higher liquidity.
The Process of Lending Asset-based lenders place more emphasis on collateral quality than borrower cash flow or credit score. They assess the credit-worthiness of the creditor by looking at their capacity for repayment and history of prior payments. However, internal bank lending guidelines impose restrictions on traditional bank lenders.Banks, for instance, often won't lend to businesses with debt-to-capital ratios higher than four. Independent asset-based lenders, on the other hand, are not bound by such restrictions, giving them the freedom to finance a large number of small businesses that are sound enterprises with promising long-term prospects but lack adequate capital or in some other way do not meet the standards of traditional bank lending.
Capacity In asset backed loans the capacity as to how much loan a firm can avail depends on its assets. Generally cash, accounts receivables, real estate, inventory, machinery, and equipment are the company's primary qualifying assets for ABL. Whereas in traditional bank lending the capacity of obtaining funds depends on the leverage of the company, its cash flow, and its capacity to access bank lenders .
FAQs on Asset-Based Lending
What can be used as collateral?
Businesses seeking loans via asset-based lending can use machinery, equipment, stocks, receivables, etc as collateral.
Do asset-based loans have good interest rates?
Asset-based loans have substantially lower interest rates than unsecured loans since the lender can recover most of its losses if the borrower fails to repay the amount.
What can happen to the collateral if I can’t pay my asset-based loan?
According to the loan agreement terms, the lender has the right to sell the collateral if the borrower misses some loan payments in a row to partially or fully recover their losses.
Is the business financing available through asset-based lending stagnant?
No. Asset-based lending's ability to provide corporate funding is always changing. A company’s ability to borrow more money will increase as the company’s assets increase. However, it's important to know that while some assets, like real estate, can increase in value over time, other assets, like business vehicles, may degrade. It is crucial to conduct frequent evaluations to make sure that the firm is utilizing asset-based lending to its fullest potential.
Does company size matter in qualifying for an ABL?
No. As long as a company's operations fit well with asset-based lenders' criteria, it can apply for an ABL.
What about intangible assets?
Intangible assets, including trademarks, patents, and other intellectual property assets can be used for asset-backed lending by pledging them or transferring rights to cash flows that are generated from these assets.