It’s Time to Take a New Look at Asset Based Lending
There are many misunderstandings amongst CFOs and finance executives when it concerns asset-based lending. The greatest is that asset-based lending is a financing option of last resort – one that only ” hopeless” companies that can’t secure a traditional bank loan or line of credit would think of. See Transportation Factoring Companies.
With the economic decline and resulting credit crunch of the past few years, though, many companies that might have gotten more traditional kinds of bank financing in the past have instead turned to asset-based lending. And to their surprise, many have discovered asset-based lending to be a flexible and cost-effective financing tool.
What Asset-Based Lending Looks Like
A conventional asset-based lending scenario frequently looks something similar to this: A business has made it through the recession and financial crisis by aggressively managing receivables and inventory and delaying replacement capital expenditures. Since the economy is in recovery (albeit a weak one), it will need to rebuild working capital in order to fund new receivables and inventory and fill new orders.
However, 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 solid bank relationships can run afoul of loan covenants if they suffer short-term losses, in some cases compelling banks to rescind on credit lines or drop credit line increases. A couple of bad quarters doesn’t necessarily indicate that a business is in difficulty, but sometimes bankers’ hands are tied and they’re forced to make financing moves they might not have a few years ago, before the credit crunch altered the rules.
In situations like this, asset-based lending can deliver the needed finances to help businesses survive the storm. Companies with strong accounts receivable and a solid base of creditworthy customers tend to be the best candidates for asset-based advances.
With traditional bank loans, the banker is predominantly concerned with the borrower’s predicted 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 to evaluate future cash flow. Asset-based lenders, conversely, are mostly worried about the performance of the assets being pledged as collateral, be they machinery, inventory or accounts receivable.
Therefore before lending, asset-based lenders will usually have machinery or equipment independently valued by an appraiser. For inventory-backed loans, they usually require regular reports on inventory levels, in addition to liquidation valuations of the raw and finished inventory. And for loans backed by accounts receivable, they typically perform comprehensive analyses of the eligibility of the collateral based on past due, concentrations and quality of the debtor base. But compared with 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 effectively an umbrella term that covers several different styles of loans that are secured by the assets of the borrower. The two primary types of asset-based loans are factoring and accounts receivable (A/R) financing.
Factoring is the outright purchase of a business’ outstanding accounts receivable by a commercial finance company (or factor). Commonly, the factor will advance the business between 70 and 90 percent of the value of the receivable at the time of purchase; the balance, less the factoring fee, is released when the invoice is collected. The factoring fee typically ranges from 1.5-3 .0 percent, depending upon such things as the collection risk and the amount of days the funds are in use.
Under a contract, the business can usually pick and choose which invoices to sell to the factoring company. As soon as it buys an invoice, the factoring company manages the receivable until it is paid. The factoring company will practically become the business’ defacto credit manager and A/R department, ” carrying out credit checks, evaluating credit reports, and mailing and documenting invoices and payments.”.
A/R financing, on the other hand, is similar to a typical bank loan, with some key differences. Although bank loans may be secured by several kinds of collateral including equipment, real estate and/or the personal assets of the business owner, A/R financing is backed strictly by a pledge of the business’ outstanding accounts receivable.
Under an A/R financing arrangement, a borrowing base is set up 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 under 90 days old to count toward the borrowing base. There are usually other eligibility covenants like cross-aged, concentration limits on any one customer, and government or international customers, depending upon the lender. In some cases, the underlying business (i.e., the end customer) must be considered creditworthy by the finance company if this customer constitutes a majority of the collateral. Also see Transportation Factoring Companies.