There are countless misperceptions amongst CFOs and finance executives when it concerns asset-based lending. The most significant is that asset-based lending is a financing choice of last resort - one that only " hopeless" companies that can't get a traditional bank loan or line of credit would think about.
With the economic slump and resulting credit crunch of the past few years, though, many companies that might have qualified for more traditional kinds of bank financing previously have now relied on asset-based lending. And to their shock, many have found asset-based lending to become a flexible and cost-effective financing tool.
What Asset-Based Lending Looks Like
A common asset-based lending scenario often looks something like this: A business has gotten through the recession and financial crisis by aggressively managing receivables and inventory and postponing replacement capital expenditures. Now that the economy is in recovery (albeit a weak one), it needs to build up working capital so as to fund new receivables and inventory and fill new orders.
Unfortunately, the business no longer qualifies for traditional bank loans or lines of credit due to high leverage, weakening collateral and/or substantial losses. From the bank's viewpoint, the business is no longer creditworthy.
Even businesses with durable bank relationships can run afoul of loan covenants if they sustain short-term losses, sometimes requiring banks to rescind on credit lines or decline credit line increases. A couple of bad quarters doesn't necessarily signify that a business is in difficulty, but in some cases bankers' hands are tied and they're forced to make financing decisions they might not have a few years ago, before the credit crunch modified the rules.
In instances like this, asset-based lending can deliver much-needed finances to help businesses withstand the storm. Companies with good accounts receivable and a solid base of creditworthy customers tend to be the best candidates for asset-based advances.
With standard bank loans, the banker is largely worried about the borrower's forecasted cash flow, which will supply the funds to repay the loan. That is why, bankers pay particularly close attention to the borrower's balance sheet and income statement so as to gauge future cash flow. Asset-based lenders, however, are mainly concerned with the performance of the assets being pledged as collateral, be they machinery, inventory or accounts receivable.
Therefore before lending, asset-based lenders will generally have machinery or equipment independently valued by an appraiser. For inventory-backed loans, they normally demand regular reports on inventory levels, in addition to liquidation valuations of the raw and finished inventory. And for loans supported by accounts receivable, they generally perform comprehensive analyses of the eligibility of the collateral based on past due, concentrations and quality of the debtor base. But as opposed to banks, they normally do not place tenuous financial covenants on loans (e.g., a maximum debt-to-EBITDA ratio).
Asset-Based Lending: The Nuts and Bolts
Asset-based lending is actually an umbrella term that covers several different types of loans that are secured by the assets of the borrower. The two main types of asset-based loans are factoring and accounts receivable (A/R) financing.
Invoice Factoring is the outright purchase of a business' outstanding accounts receivable by a commercial finance company (or factor). Normally, the factor will advance the business between 70 and 90 percent of the value of the receivable at the moment of purchase; the balance, less the factoring fee, is released when the invoice is collected. The invoice factoring fee typically ranges from 1.5-3 .0 percent, depending upon such factors as the collection risk and the number of days the funds are in use.
Under a contract, the business can usually pick and choose which invoices to sell to the factor. As soon as it purchases an invoice, the invoice factoring company deals with the receivable until it is paid. The factoring company will practically become the business' defacto credit manager and A/R department, " doing credit checks, analyzing credit reports, and mailing and documenting invoices and payments.".
A/R financing, meanwhile, is similar to a traditional bank loan, but with some key differences. While bank loans may be secured by different kinds of collateral including equipment, real estate and/or the personal assets of the business owner, A/R financing is backed purely by a pledge of the business' outstanding accounts receivable.
Under an A/R financing arrangement, a borrowing base is created at each draw, against which the business can borrow. A collateral management fee is charged against the outstanding amount, and when funds are advanced, interest is assessed only on the amount of money actually borrowed.
An invoice typically must be less than 90 days old so as to count toward the borrowing base. There are frequently other eligibility covenants for example, cross-aged, concentration limits on any one customer, and government or international customers, depending upon the lender. Sometimes, the underlying business (i.e., the end customer) must be regarded creditworthy by the finance company if this customer comprises a majority of the collateral
