What Makes Asset Based Loans So Different From Other Loans

Posted on: November 29th, 2017

Asset Based LoansAsset based loans represent an important segment within the world of finance. Asset based loans are advanced against specific collateral of the Company, such as a line of credit extended against the accounts receivable or a term loan extended against equipment value.

Asset based lenders use the liquidation value of the collateral as the basis for making the loan. If the liquidation value of the underlying collateral is greater than the amount of the loan being sought, then the asset based lender will extend the loan.

Asset based lending is distinct from other forms of lending such as cash flow lending, where there is emphasis on the profitability of the company. Asset based lenders are first and foremost collateral lenders, and are not able to provide a loan unless the company’s collateral meets their requirements.

Tip #1 – Asset based lenders are 100% collateral focused.

Tip #2 – The larger your collateral base, the larger the loan size.

Tip #3 -Asset based loans are usually used for funding ongoing working capital needs.

They see the company as the sum of assets as opposed to a multiple of its cash flow, like cash flow lenders do. There are many varieties of asset based lenders, based on type of collateral, size and credit rating of company.

Asset based loans are different than other loans because the quality of the asset collateral determines the size and pricing of the loan. Companies that are loss-making or have weak cash flow, can qualify for a large asset based loan amount if they have the right type of collateral.

For an asset based lender, the risk profile of the loan is more reflective of the recoverable value of the collateral as opposed to the overall creditworthiness of the borrower.

If the company has weak credit but has strong accounts receivable with blue chip customers or highly saleable inventory, then it can raise an asset based loan. This helps companies going through transitional difficulties, as they can easily bring in asset based lending which can help fund them during the challenging period.

Asset based loans generally have shorter maturities than cash flow based term loans, and do not always require loan principal repayment throughout the term.

Ongoing management of the collateral position of the company is important to the asset based lender, as they require the borrower to be within a predetermined borrowing base.

Tip #4 – The Borrowing Base calculation determines the amount of your loan advance.

The borrowing base is the framework for the measurement of the collateral value. It is continually refreshed on a daily or weekly basis to ensure that the company’s collateral is adequate to support the loans.

Through specific reporting requirements and collateral appraisals, the lender is able to manage the relationship to ensure the loan stays within the predetermined collateral parameters.

For loans against receivables and inventory, the borrowing base is usually set at an advance rate of 80% against eligible receivables and 50% against eligible inventory. For loans against equipment, the advance rates range from 50% to 80% of orderly liquidation value.

How do you qualify for an asset based loan?

Asset based lenders conduct evaluations of your assets to determine the loan size they can offer. They conduct an accounts receivable eligibility appraisal and an inventory eligibility appraisal.

If equipment is involved, they will have a physical inspection of the equipment and determine its current market value. The best way to understand how much you will qualify for is to conduct your own analysis of asset eligibility.

For collateral such as accounts receivable, the general conditions are for receivables under 90 days of age, from domestic customers, that are final sales, with no amounts owing to the customer as an accounts payable.

Tip #5 – Conduct an internal assessment of your asset eligibility before applying for the loan.

Tip #6 – Clean up any accounting issues before you apply for the loan.

For inventory, the general conditions are no work in process or old inventory, no small parts inventory that would be difficult to resell. Also, all inventory much be warehoused in a location controlled by the borrower.

For equipment based asset based loans, the lender orders a third party appraisal. Assessing the asset eligibility on a current basis is the best way to determine the loan size available.

Asset based lenders also require a first position on all assets, and that there are no other liens on the assets they are lending against. If there are pre-existing liens or large claims on the company, this is problematic for the asset based lender.

For example, if a company owes the IRS for back taxes, the IRS can file a lien against all of the company’s assets, making it difficult for the company to attract a new lender until the lien is paid off.

The key with qualifying for an asset based loan is to know your own eligibility status before the lender commences their assessment.

Often, companies that don’t already have a lender have no need to produce a monthly financial statement and may not record all asset values at their proper levels.

A company may not record all accounts receivable at month end or may not capitalize all inventory in accordance with GAAP.

Before you conduct your own eligibility assessment, you should ensure that the books and records are cleaned up and reflect accurate and timely financial information.

Additionally, you should ensure that all cash collections, all payroll, all purchases, and all invoicing is fully reflected in your general ledger. As part of their due diligence, the lender will verify that all financial transactions are properly recorded in your internal accounting system.

What at the advantages of asset based loans over other loans?

Asset based loans are relatively easy to source and to close, provided the lender’s collateral requirements are met. Asset based loans are versatile and can be used for a variety of capital needs.

They can be used in a commercial finance context where the funds are used to supplement the working capital needs of the company as it grows. Alternatively, they can be used to fund an acquisition of another business.

Because asset based lenders are narrowly focused on collateral considerations, they are more relaxed about how the proceeds of the loan gets used. Unlike a bank or mezzanine lender providing a cash flow loan, they are less concerned as to how the proceeds of their loan are being used.

Their asset centric credit view works to the benefit of the borrower engaged in an acquisition. Whereas a mezzanine lender would likely not be comfortable providing 100% of the capital needed for an acquisition, an asset based lender is indifferent to the use of their funds and can fund 100% of an acquisition.

Tip # 7 – Asset based loans are widely available and easy to source.

Tip # 8 – Asset based loans can be closed quickly.

Deals that can be closed with 100% asset based financing are relatively rare in the M&A world but they do happen from time to time. As importantly, because the size of the asset based loan facility is set by the level of the borrowing base, the asset based lender is able to scale with the growth of the borrower.

If the company’s collateral base increases 10%, the amount available for borrowing has likely increased 10%. Conversely, if the company contracts, the amount outstanding under the asset based facility usually contracts on a pro rata basis.

Asset based loans are easier to source and close than cash flow based loans. There are many available asset based loan options, both through local lenders and through the web based lenders, though it pays to know the differences between the lender categories.

The asset based lending process is efficient and straightforward. It can usually be completed in less than 30 days, which gives it a speed advantage over other forms of lending.

Due to the large number of asset based lenders in the market, it relatively easy to find several lenders that may fit your specific financing need.

What are the disadvantages of asset based loans versus other loans?

Asset based lending is characterized by collateral requirements, rigid lender terms, and intensive reporting requirements. Loans are not customized to fit the needs of the borrowers as much as they are customized to conform to the collateral requirements of the lender.

Asset based lending is a traditional form of finance and it is not known for its creativity and flexibility.

Tip #9 – Asset based loans provide significantly less funding than other loans.

Tip #10 – They should not be used to fund a long term project, due to their variable availability and short term maturity.

Their credit guidelines are strict and not suited to asset light companies, especially service companies or technology companies with low levels of working capital and fixed assets on their balance sheets. As a result, asset based lenders are not a viable growth capital option for many different types of companies.

Regardless of the type of institution providing the asset based loan – whether it is a bank, a finance company or a factoring company, they simply cannot fund into loan that has a collateral shortfall position. This seriously constrains their ability to provide impactful levels of capital to companies.

In addition, due to their inability to size their loans based upon EBITDA or Cash flow, asset based lenders often provide only a small fraction of the funding need of a company. When companies acquire other companies, the purchase price usually significantly exceeds the value of the collateral of the company being acquired.

So companies that need acquisition financing cannot look to asset based lending to provide much financing in an acquisition scenario unless the company being acquired has a large amount of collateral on its balance sheet.

Asset based lenders are generally are not long term focused and usually have maturity terms of under 3 years. At the end of the term of the loan, they either have to renew the facility or be refinanced out, by another lender.

Finally, a real downside to dealing with an asset based lender is the extreme focus on perfecting their collateral and their real threat of liquidation. Account receivable lenders often require a lockbox collection set up for all borrowers.

This means that your customers will have to mail their payments to an account controlled by the lender. Many companies do not want their customers to know they are under a lockbox, because it means their bank controls their liquidity.

If the Company hits a rough patch, the lender has the ability to just collect the cash and apply it to their loan, which liquidates the collateral and chokes the borrower’s liquidity.

In a downside situation, asset based lenders are more concerned with getting their money back than they are preserving the liquidity position of their borrowers.

What are the best things to do with an asset based loan?

Asset based loans are an essential building block of liquidity management for all companies. Every company should have a line of credit that allows for credit to be drawn against eligible receivables and inventory.

Most asset based structures are used to fund the ongoing working capital needs of the business, whether it is managing seasonality or providing more working capital to fund big orders.

Tip #11 – Best used for smoothing out your working capital swings.

It smooths out cash flow management and provides a valuable liquidity bridge for companies. In addition, asset based loans are helpful to fund a portion of the purchase price of an acquisition.

While it will likely not deliver more than 35% of the financing needed, asset based financing is generally lower cost than cash flow based financing if sourced from a bank.

It is helpful also for funding equipment purchases and expansions, as long as the drawdown does not push the loan balance too close to the edge of the borrowing base.

Despite its many advantages, asset based lending is classified as short term capital because of the volatility of the borrowing base and its short term maturity.

It should be used only sparingly to fund long term project such as acquisitions and large scale expansions.

  • Banks and Finance Companies are the best providers of asset based loans.
  • Use factoring companies only as a last resort.

The Finance company segment includes business development corporations, specialty public lenders, and independent collateral focused lenders.

These companies do not have the same cost of funds as a bank so their rates are higher – generally Libor plus 450 to 850 basis points, depending on the size of the deal and quality of the collateral.

The third tier of asset based lenders are small receivables-focused groups known as factors or receivable management firms. These firms are expensive to deal with – generally an effective rate of 18% to 35% per annum plus a host of fees.

Banks and Finance companies offer reliable execution and loans you can build into sensible capital structure. Factoring companies are a last resort and consume most of the profit of the borrower.