Asset-Based Line of Credit: How to Know If It’s Right for Your Business
Ezra Cabrera | August 23, 2022
Key Takeaways
- Asset-based lines of credit rely mainly on the value of the collateral presented by the borrower, which usually includes real- estate, inventory, and equipment.
- One of the surefire benefits of an asset-based line of credit includes faster approvals and funding than traditional bank loans.
- As a downside, an asset-based line of credit comes with higher interest rates than traditional bank loans and the risk of giving up your collateral if you default on the loan.
Whether a corporation is a startup or a well-established conglomerate, it runs on borrowed capital in the same manner that a vehicle runs on gasoline. When it comes to financing, businesses tend to have more options than individuals, making corporate borrowing slightly more complicated than the available personal borrowing choices.
Companies may borrow money from banks or other financial institutions to fund their operations, acquire another enterprise, or make a substantial purchase. To accomplish these goals, a business may consider various options and lenders. Similar to personal loans, business loans can be structured as either secured or unsecured.
Within these two broad categories, financial institutions can offer a broad range of lending provisions to accommodate every borrower. Unsecured loans aren't backed by collateral, whereas secured loans are. Under the secured loan category, the asset-based line of credit can be considered a potential financing option.
In this article, we will discuss the asset-based line of credit in detail to help companies determine whether it’s the best option to help their business grow.
What is an Asset-Based Line of Credit?
So what’s an asset-based line of credit exactly? Simply put, it’s a financing option secured by assets, most commonly accounts receivable and inventories. It involves a company putting its future earnings on the line to gain access to funding right now.
Asset-based lenders will advance payments based on an agreed-upon percentage of the value of the secured assets. The amount is typically 70% to 80% of eligible receivables and 50% of finished inventory.
How Does an Asset-Based Line of Credit Work?
Many businesses opt to secure loans or lines of credit to satisfy regular cash flow demands. For instance, a company may take advantage of a line of credit to ensure that it can cover its payroll obligations even if the payments it expects to receive are briefly delayed.
If the company seeking the loan is unable to present adequate cash flow or cash assets to cover the loan, the lender may propose to sanction the loan using physical assets as collateral. Through this process, a new restaurant may be able to secure a loan by utilizing its equipment as collateral.
The terms and conditions of an asset-based line of credit are determined by the type and value of assets used as collateral. Lenders usually favor highly liquid collateral, such as securities, which can be easily converted to cash if the borrower fails to complete the payments.
Physical asset loans are generally riskier, which is why the maximum loan will be significantly less than the asset's book value. The interest rates charged vary greatly depending on the company's cash flow, credit history, and length of time in business.
How to Obtain an Asset-Based Line of Credit?
Numerous financial service companies offer an asset-backed line of credit. It includes various banks and independent financing institutions. Finding lenders ready to extend lines of credit to startup companies is critical for many businesses. Accomplishing this task can be challenging and often requires some asking around.
Asset-based lenders usually prefer to provide larger loan amounts since the expense of monitoring loans of this type is essentially the same, regardless of size. However, obtaining an asset-based loan should still be simple if a company has good financial statements, transparent reporting systems, often sold inventory, and customers who pay their bills consistently.
To secure an asset-based loan, a company needs to provide detailed and accurate information about its finances. The key is ensuring the lender feels at ease with a credible case for the business's long-term viability. Also, professionally-crafted financial statements showing that the owner knows what their doing with the business will surely help.
Upsides of an Asset-Based Line of Credit
The following are the advantages of obtaining an asset-based line of credit:
Puts Prized Assets to Good Use
Businesses with fixed assets on their balance sheet can use them to gain additional working capital. Whether the company has spent resources on business equipment or inventory, those investments can be used to get additional funding for the business.
Has a Lower Associated Cost than Comparable Solutions
Most asset-based financing programs are more affordable than other alternatives, such as factoring. While asset-based lines of credit are priced with an annual percentage rate (APR), factoring lines are priced by discounting the total value of the invoice by a certain percentage.
Provides Greater Flexibility Compared to Other Types of Financing
There aren't many rules about how the funds should be used in an asset-based financing program, as long as the purpose is related to business. Since the money is tied to the value of a company's assets, the amount of the funding can go up as the value of the assets grow.
Easier to Get Approved than other Loans and Business Lines of Credit
Finally, asset-based financing programs are easier to obtain approval for because the primary qualification is to utilize assets to secure a loan. With asset-based lending, the lender is provided security by the collateral used to secure the loan or line of credit.
Downsides of an Asset-Based Line of Credit
Meanwhile, the following are the downsides of obtaining an asset-based line of credit:
Losing Valuable Assets is Always a Risk
If the borrower defaults on the loan, the lender may seize the asset posted as collateral to secure the loan or line of credit. The lender may liquidate the collateral to recoup the funds issued to the borrower.
Not All Assets Make the Cut as Collateral
Lenders impose specific terms and conditions on assets before they can be used as loan collateral. To qualify, an asset must be of high value, low depreciation rate, or a high appreciation rate and can easily be converted into cash.
Costs More than a Conventional Loan
Compared to traditional loans, asset-based lines of credit or loans have higher administration and origination costs.
Also, the cost of initial underwriting, collateral assessment, and monitoring is substantially higher than conventional financing methods.
Ideal Businesses to Utilize Asset-Based Lines of Credit
Private Equity Enterprises
It can be challenging for private equity firms and their portfolio companies to find the optimal capital structure. Since the cost of debt is often lower than the cost of equity capital, unique lending structures are required in most sponsored scenarios.
Aside from the capacity to go beyond historical financial performance, the structure of asset-based lines of credit provides increased financial flexibility.
Since capital availability can rise with the asset base's value, an asset-based financing structure isn't only likely to maximize access to debt capital for the acquisition. It can also grow with the portfolio company as the private equity presence, and growth plans are put into motion.
Seasonal Businesses
Asset-based loans are ideal for businesses that have seasonal sales cycles. Many suppliers and distributors have cyclical revenue because of their specific market or trade.
For instance, fence construction companies usually see an increase in sales during the warmer months. A company like this will need to stock up on assets and inventory in preparation for the busy season.
Borrowing based on cash flows may not provide enough credit to cover the busiest part of the season adequately, but leveraging the asset base creates liquidity when it's most needed.
Rapid Growth Companies
Like seasonal campaigns, rapid-growth companies may have the same need for an asset-based line of credit.
Suppose a mid-sized manufacturer agrees to a contract enabling rapid expansion of production, but its historical cash flows don't indicate the capacity to borrow capital for growth. In that case, the company will require additional financing to fuel expansion. It will then look toward its asset base as security for the new venture to scale its enterprise effectively.
The increased capital available through an ABL credit agreement may allow the company to hire additional staff and stock up on inventory and other assets to support expansion before revenue from the new agreement begins.
Transitioning Companies
Owners of mid-sized businesses frequently find that most of their wealth is tied to the business. Although the net worth can be significant, it's also relatively illiquid. So when the time comes that the current owner is set to retire, the ownership group needs to shift to new challenges or look for equity investors to find new growth opportunities. In this instance, an asset-based line of credit presents itself as a viable alternative.
The company can generate more capital to execute a transition in ownership by leveraging the asset base than it would typically obtain through cash flow financing. This additional "leverage" may be too risky for many lending partnerships, but the added security provided by asset-based lines of credit can facilitate a smooth transition.
Conclusion
When a traditional lender or financial institution is unable to provide funding, business owners often resort to asset-based lending.
It's essential to highlight that with asset-based lending, borrowers don't sell their assets. Instead, they're only borrowing against them. And since assets are used as collateral, the lender can claim them if the company fails to meet the payment terms.
Therefore, you must consider the risks and benefits of your business before deciding whether an asset-based line of credit is the best option. Indeed, it's the most viable choice in the right circumstances for the right type of business.
Asset-Based Line of Credit: Frequently Asked Questions
Do asset-based loans have low-interest rates?
Since asset-based lines of credit are secured, they can offer a better deal than unsecured loans because they often come with lower interest rates.
What role does collateral play in asset-based loan qualification?
Traditional loans are based on credit and cash flow, while asset-based lines of credit are based on underlying collateral and the company's financial situation, ownership, and organizational management.
Often, it's easier to get approved for an asset-based line of credit than for credit-based loans.
What will happen to the collateral if I am unable to repay my asset-based loan?
The lender may claim the secured assets if you fail to meet the loan repayment terms. As a result, you must take advantage of this type of financing only when you're certain you'll be able to make the payments on time over the entire term.
About the Author
