How Does Asset-based Lending Work?
You may have heard the term “ABL,” but you may not understand how asset-based lending works. In this three-minute read, you’ll get an overview. If you’re looking for new ways to secure funding, ideally as a result of growth and good strategic pivots, asset-based lending (ABL) may be a viable option. Asset-based lending works by using existing assets as collateral for a loan, such as accounts receivable, inventory, machinery, or equipment. Here are the fundamentals of asset-based lending and how it may benefit you.
What is the Process of Asset-based Lending?
What is asset based lending? The procedure for evaluating you for asset-based lending financing varies from the more known approach for cash-flow financing. Standard cash flow indicators include financed debt divided by EBITDA (earnings before interest, taxes, depreciation, and amortization), EBITDA margin (EBITDA as a percentage of sales), and operational cash flow.
A lender will instead concentrate mainly on the value of your assets, which will be used as collateral to obtain a loan, using asset-based lending. Accounts receivable is first on the list; usually, only current receivables (those that are fewer than 90 days from the invoice date or no more than 60 days past due) are evaluated. Then there’s inventory, machinery and equipment, real estate, and intellectual property.
You will be subjected to field inspections as part of this procedure to evaluate the amount and quality of its financial and physical assets. The qualifying collateral and the advance rates against it are determined by the field inspection and inventory evaluation.
One benefit of asset-based lending is the lack of restrictions that often accompany cash-flow loans, such as requirements that businesses maintain specific levels of debt payment coverage and leverage. When a business experiences a decrease in sales, as many did during the coronavirus outbreak, a company’s cash flow may fail to fulfill its covenants. To safeguard against loan losses, a lender may restrict credit availability, raise interest rates, or take other steps. Having your loan backed by your company’s assets, on the other hand, reduces a lender’s concerns about a potential default. To avoid being subject to a financial covenant, your company will simply need to maintain a minimal level of liquidity.
Different Kinds of Asset-based Lending
Let’s take a look at the most prevalent kinds of asset-based loans. This will assist you in selecting the best one for your specific requirements.
Invoice Financing
Even under the best of circumstances, business is unpredictable. Small companies with lengthy billing cycles may perish as a result of this uncertainty. If you have to wait more than 30 days to collect your accounts receivable, your small company may have cash flow problems.
An asset-based lender will give you money based on your current invoices if you use invoice financing. Invoice finance is related to, but not identical to, invoice factoring. You keep control of your assets while using invoice finance. Your current invoices are sold to a third party via invoice factoring.
Inventory Financing
Inventory finance is a fantastic loan option if you already have a large quantity of inventory on hand, even if you have less-than-perfect credit. Although inventory-based financing does not cover the full value of your physical goods, you will still get the majority of its value.
Equipment Financing
To get off the ground, every company needs some sort of equipment. This may make it tough to start your company if you need excessively costly equipment. Equipment financing allows you to get started without incurring an unreasonably high up-front cost.
Business Lines of Credit
For company loans, credit lines are very popular. That’s because they’re so important. Even in the best of circumstances, it’s impossible to predict how much money you’ll need to run a company. That becomes next-to-impossible when you don’t even know how much money you’ll be bringing in. When you need it, you may get a business line of credit. Even if you have a well-established company, having them on hand is a smart idea. Things happen, often unexpectedly. Don’t allow the uncertainty of life to disrupt your life’s ambition!
To know more about how asset based lending works you can even try reading some asset based lending books like The history of asset-based lending by Sidney Rutberg, Asset Based Lending Disciplines: Field Examinations, Accounts Management and Collateral Analysis for Asset Based Lenders by Donald Clarke.
The Benefits of Asset-Based Lending
Now that you understand the most prevalent kinds of asset-based lending and how they operate, you may be asking why you would choose this sort of financing. After all, obtaining one of these loans entails putting a substantial portion of your assets on the line.
Many borrowers seek asset-based lending because they have had difficulties obtaining funding from conventional lenders. As a result, you may discover that an asset-backed loan is well-suited to your requirements.
With this in mind, consider some of the reasons you could utilize asset-based lending:
- Easier to Qualify For
- Excellent for Meeting Working Capital and Cash Flow Needs
- Less Personal Risk Requirement
- Flexible Financing Solution
It’s also worth mentioning that the value of your assets limits the amount of money you may borrow with an asset-based loan. If you require a big sum of money but don’t have the assets to back it up, you’ll have a difficult time getting the money you need.
How Much Money Can You Borrow?
Loan sizes for asset-based lending are often very big, implying that fewer lenders are available at this upper end of the market. The good news is that this implies lenders are much more likely to take a personalized approach towards you — rather than a “computer says no” approach.
Asset based lending statistics suggest that the total credit commitments rose by 2.0% in 2020.
Asset Based Lending Terms You Should Know
Advance – A drawdown or disbursement of funds according to the terms of an existing loan agreement.
Advance Rate – The maximum percentage that the lender will lend against a type of collateral.
Blanket Assignment – An arrangement that grants the lender a security interest in all of the borrower’s assets.
Compliance Certifications – The borrower’s declaration attesting to its adherence to the loan agreement’s provisions throughout the specified time.
Credit Memo – A comprehensive memorandum sent from one party or firm to another providing credit for returned merchandise, an omission, an overpayment, or some other reason.
Cross-Collateralized Loans – In the case of a default, the collateral of cross-collateralized loans is utilized to pay obligations.
Cross Default – The right to declare a loan in default if another loan has a default event.
Debtor-in-Possession (DIP) Financing – Financing made available to a borrower after the filing of chapter 11 (reorganization) bankruptcy petition. A lender offers post-petition funding to the DIP to support its working capital requirements as the DIP tries to repair its financial situation and exit bankruptcy protection.
Eligible Collateral – A loan agreement phrase that specifies what collateral may be included in the borrowing base.
Formula – A calculation to determine the borrowing base in which a margin or advance rate is applied to each type of collateral.
Ineligible Collateral – Pledged receivables or inventory that does not satisfy the loan agreement’s requirements. Ineligible collateral stays in the ABL lender’s collateral pool but is not eligible to be included in the borrowing base.
Lien – A legal right given by a court’s power to control or enforce a charge against the property of another until some lawful demand is paid or otherwise fulfilled.
Liquidation Value – The most probable price an asset will fetch if sold without adequate market exposure and under pressure.
Lock Box – A cash management tool provided by banking institutions that expedites a client’s receivables collection.
Notification – The bank informs a borrower’s pledged accounts that payments must be sent directly to the bank for collection.
Operating Cycle – The period of time it takes a business to convert purchased and manufactured goods and services into sales, plus the time to collect the cash from the associated sales.
Pari Passu Credit Facilities – Credit facilities in which two or more lenders are treated equally under a credit arrangement. The term “collateral” is most often used to refer to collateral, although it may also relate to loan structure, paperwork, maturity, or any other substantive condition.
Revolving Credit Facility – A credit arrangement that enables the borrower to draw down and repay advances on a regular basis. The profits are often utilized to meet the borrower’s working capital requirements.
Set-off – A lender’s common law power to take deposits held by a debtor and placed in the lender’s institution in the event of nonpayment of an obligation.
Uniform Commercial Code (UCC) – A model legal framework that governs commercial transactions.
Working Investment – The total of accounts receivable and inventory less the sum of accounts payable and accrued expenditures (excluding taxes). It denotes the amount of finance and trade assistance required by a business to fund its trading assets.
Conclusion
Asset-based lending benefits both the lender and the borrower. If the borrower defaults, the lender has an asset that may be sold to recoup the amount loaned. Because asset-based lenders are less concerned with a company’s previous cash flow, profitability, or even personal credit scores, the ABL allows the borrower to utilize this method to borrow money when other options, such as selling bonds or unsecured loans, are not available.
Factoring is often mistaken with asset-based lending. They have numerous similarities, including the use of receivables as collateral, but there are few distinctions. In factoring, a person does not borrow money and instead sells his receivables at a discount in order to enhance his cash flow, while in the asset based lending industry, a person borrows the money using the receivables as collateral.
Additional Read
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