Understanding Asset-Based Financing Companies
Ezra Cabrera | February 20, 2022
Key Takeaways
- Any loan where an asset serves as collateral is referred to as asset-based lending.
- Asset-based lending is deemed less risky than an unsecured loan.
- Lenders may be less interested in physical assets such as machinery, buildings, or even inventory, and most especially with liquid assets.
Understanding Asset-Based Financing Companies
There are now many asset-based financing companies in the US, but what do they do and what services do they offer?
Simply put, any loan that is backed by an asset, or where an asset serves as collateral, is referred to as asset-based lending.
Put it an even much simpler way, in asset-based lending, the lender’s loan is secured by the borrower’s asset/s.
Asset-based financing is a specialized type of funding to provide working capital and term loans to businesses. It can leverage a business’s assets such as its accounts receivable, inventory, machinery, or equipment. Even real estate tied to the business can serve as collateral. Any loan secured by one of the company’s assets is referred to as a secured loan. Asset-based financing is also known as commercial finance or asset-based lending.
Usually, asset-based financing is used by business owners to cover expenses when there are temporary gaps in their company’s cash flows. It can also help them survive seasonal sales dips.
This type of financing can also help cover the normal delays in the cash collection cycle. For example, there may be delays between buying raw materials and receiving cash for goods or services from customers.
Asset-based financing can also be used to fund startup companies. It can also be very useful if a business wants to refinance existing loans, finance growth, mergers and acquisitions, and even management buy-outs (MBIs).
Examples of Asset-Based Financing
As mentioned above, this loan is secured by the borrower’s assets, which may also include inventory, marketable securities, and equipment. Asset-based lending is deemed less risky than an unsecured loan–or a loan that isn’t backed by any assets.
Since lenders face less risk, the interest rate charged may be lower. Furthermore, the more “liquid” the asset, the lower the interest rate as the loan becomes even riskier. When we say “liquid asset,” we pertain to any asset that can be converted into cash quite easily and quickly. Some examples of liquid assets, aside from cash itself, are money market instruments and marketable securities. This is also why lenders may check the liquid assets reported on a company’s balance sheets.
Going back to asset-based financing, an asset-based loan secured by accounts receivables, for example, is considered safer than an asset-based loan secured by a property. This is because the property is not a liquid asset. In case the borrower defaults, the lender may find it difficult to liquidate the asset rapidly on the market.
Purchase order financing is another example of asset-based finance. This may be appealing to any business that has already exhausted its credit limits with lenders and vendors, as well exhausted all possibilities for bank loans. Therefore, its inability to purchase supplies (which leads to fulfilling all customer requests) would then result in a company running over its capacity, potentially putting it out of business.
What will be done in purchase order financing is this: the asset-based lender finances the purchase of raw materials from the company’s supplier. This is done through a purchase order financing arrangement. Typically, the lender pays the supplier directly. The company would invoice its customer for the remaining payable after the orders have been filled. The consumer then would pay the asset-based lender directly for the accounts receivable.
The lender then subtracts the financing cost and fees from the payment. Afterward, the lender remits the balance to the business owner. However, the main disadvantage of purchase financing is the high interest rate. It can go up even higher than 10%. However, because of the loan’s collateral, the lender is given a chance to recuperate any losses if the borrower defaults. Overall, these loans still have lower interest rates as compared to unsecured loans.
Who Benefits from Asset-Based Financing?
Asset-based loans can take the form of either a cash loan (lump sum) or a line of credit. Because of this, stable small and mid-sized businesses with valuable physical assets are the most common clients of asset-based lenders. Larger firms, on the other hand, may still apply for asset-based loans from time to time, especially if they need to satisfy short-term liquidity demands.
Since asset-based finance lenders prefer liquid assets, they tend to work with businesses with valuable assets and good financial management history. Lenders may be less interested in physical assets such as machinery, buildings, or even inventory but may still consider these as collateral.
How Much Can a Business Receive from an Asset-Based Loan?
The loan-to-value ratio is often used in asset-based financing. To most lenders, the loan-to-value ratio for an asset-based credit is 80% marketable securities. This means that they would only be willing to lend up to 80% of the marketable securities’ worth.
The loan-to-value ratio varies by asset type. For more liquid assets, for example, lenders may tend to offer a greater loan-to-value ratio.
The following formula is used to compute the loan-to-value ratio:
Loan-to-Value Ratio = The Loan Amount / The Asset Value.
Business owners should take note that the loan amount is determined by the lender. The asset value is dependent on its current market price.
Also, accounts receivables and inventories usually have loan-to-value ratios of 70% and 50%, respectively.
The Advantages of Asset-Based Financing
Asset-based lending has a number of advantages. For one, asset-based loans are easier and faster to get–especially when compared to unsecured loans and business lines of credit. They’re also more flexible as asset-based lenders often have less stringent loan agreements. They also typically have lower interest rates compared to other types of loans.
Asset-based loans don’t just provide benefits to the borrowers, however. They’re also quite beneficial to lenders. Remember that these types of loans are less risky because the assets serve as collateral. Therefore, if a borrower defaults on the loan, the lender can then seize (and possibly liquidate) the assets used to secure the loan. This then pays off the debt.
Choosing the Right Asset-Based Financing Company
One of the most crucial decisions a business owner must make is to choose the right asset-based financing company.
An evaluation process should be set up, as this ensures business owners that they can select the right asset-based lender for the situation, as well as specific financial requirements.
Here are the things to look out for:
1. Industry Experience
The most crucial thing to ask is whether or not they have experience in the business’s industry or niche. The best financing company would know the industry well and understand the risks so that the asset or collateral can be properly valued. They can also best meet certain demands because they have industry experience.
2. Ability to Cater to Specific Asset Combinations
Accounts receivable, inventory, and equipment are the assets that most lenders finance. Most lenders have experience analyzing specific sorts of assets and, as a result, favor those assets.
A business owner must then find a lender who is comfortable with their asset combination. This then improves the chances of receiving the best loan terms.
3. Funding Processes and Options
Asset-based financing companies that are linked to larger banks are often funded in the same way that banks are. The process is done through deposits, as well as the sale of certificates of deposit to institutional investors. Independent asset-based lenders, on the other hand, receive funding from a variety of sources including credit lines, private equity, and maybe even hedge funds.
What these mean is that business owners need to consider the diversity and reliability of their potential lenders’ financial streams. Some research would be needed so that they can check if they fit well with a lender’s funding process and options.
4. Additional Fees
Business owners should also closely look at all additional fees that a lender may charge. This allows them to ensure that they can better gauge the cost and that the loan is still within budget.
5. How They Deal With Customers
This is particularly important for lenders who handle accounts receivable, as they would need to process client payments. Asset-based lenders may need to directly contact clients on a regular basis. Business owners should ensure to partner only with those with a good reputation regarding handling clients.
Final Thoughts
Asset-based financing can be a good way to provide a business with additional working capital. The business can leverage its assets such as its accounts receivable, inventory, machinery, real estate, or equipment. There are many benefits that asset-based lending can provide, which is why business owners need to know about this funding option. However, they should also look closely at their current assets and determine which ones would serve best as collateral. They should also thoroughly check which lenders they want to partner with before applying for asset-based financing.
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