There are countless misperceptions amongst CFOs and finance executives when it involves asset-based lending. The greatest is that asset-based lending is a financing choice of last resort – one that only ” hopeless” companies that can’t qualify for a traditional bank loan or line of credit would look into.
With the economic slump and resulting credit crunch of the past few years, though, many companies that might have gotten more traditional forms of bank financing previously have instead gone to asset-based lending. And to their shock, many have found asset-based lending to be a flexible and cost-effective financing resource.
What Asset-Based Lending Looks Like
A common asset-based lending situation frequently looks something similar to this: A business has gotten through the recession and financial crisis by aggressively managing receivables and inventory and postponing replacement capital expenditures. Since the economy is in recovery (albeit a weak one), it will need to build up working capital so as to fund new receivables and inventory and fill new orders.
Unfortunately, the business no longer qualifies for traditional bank loans or lines of credit due to high leverage, weakening collateral and/or extreme losses. From the bank’s perspective, the business is no longer creditworthy.
Even businesses with durable bank relationships can run afoul of loan covenants if they experience short-term losses, at times forcing banks to pull the plug on credit lines or drop credit line increases. A couple of bad quarters doesn’t always indicate that a business finds themselves in trouble, but occasionally bankers’ hands are tied and they’re forced to make financing choices they might not have a few years ago, before the credit crunch changed the rules.
In instances like this, asset-based lending can deliver much-needed cash to enable businesses weather the storm. Companies with good accounts receivable and a sound base of creditworthy customers often tend to be the very best candidates for factoring advances.
With conventional bank loans, the banker is primarily concerned with the borrower’s predicted cash flow, which will provide the funds to repay the loan. Therefore, bankers pay particularly close attention to the borrower’s balance sheet and income statement so as to evaluate future cash flow. Asset-based lenders, conversely, are primarily concerned with the performance of the assets being pledged as collateral, be they machinery, inventory or accounts receivable.
So prior to lending, asset-based lenders will normally have machinery or equipment independently valued by an appraiser. For inventory-backed loans, they typically require regular reports on inventory levels, in addition to liquidation valuations of the raw and finished inventory. And for loans supported by accounts receivable, they usually perform in-depth analyses of the eligibility of the collateral based on past due, concentrations and quality of the debtor base. But unlike banks, they often 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 in fact an umbrella term that covers several different kinds 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). Typically, 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 invoice factoring fee typically ranges from 1.5-3 .0 percent, relying on such factors as the collection risk and the amount of days the funds are in use.
Under a contract, the business can usually pick which invoices to sell to the factor. The moment it purchases an invoice, the factoring company handles the receivable until it is paid. The factor will practically become the business’ defacto credit manager and A/R department, ” completing credit checks, analyzing credit reports, and mailing and documenting invoices and payments.”.
A/R financing, meanwhile, is similar to a standard bank loan, but with some key differences. Although bank loans may be secured by different kinds of collateral including equipment, real estate and/or the personal assets of the business owner, A/R financing is backed purely by a pledge of the business’ outstanding accounts receivable.
Under an A/R financing arrangement, a borrowing base is created 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 generally must be less than 90 days old to count toward the borrowing base. There are often other eligibility covenants such as cross-aged, concentration limits on any one customer, and government or international customers, depending upon the lender. In many cases, the underlying business (i.e., the end customer) must be regarded as creditworthy by the finance company if this customer makes up a majority of the collateral