If your business has assets and needs working capital to operate and grow, you might want to consider an asset based loan or line of credit. The loan’s value and security are derived from the collateral you pledge — not your financial track record — so it’s a useful form of financing if your business is young or you have less than stellar credit.
We’ll explore the ins and outs of asset based lending so you can determine if this type of financing is the right fit for your business’s needs.
Asset Based Lending: A Definition
Sometimes abbreviated as ABL, this lending is a form of business financing in which the loan is “secured” by your business’s assets. Lenders determine the borrowing base — the amount they’re willing to finance — based on the valuation of the pledged collateral. Such items include inventory, equipment and accounts receivables.
If a borrower defaults on a loan, the lender can seize and liquidate pledged assets to recoup losses.
Why Consider an Asset Backed Loan?
When considering asset based lending vs. traditional lending, or perhaps asset based lending vs. a line of credit, keep in mind these other types of financing are based on cash flow.
To qualify, your business must be established, demonstrate a history of profitability and boast a healthy credit score. If your small business fails to meet these qualifications, asset based lending is an option.
What Types of Assets Can Be Offered as Collateral?
The list of assets you can offer as collateral can be long and varied. In general, lenders prefer liquid securities — assets that can be readily converted to cash with little to no loss in value.
These are the items found at the top of your balance sheet: things such as marketable securities (stocks and bonds) and accounts receivables (outstanding payments from your customers or clients). A lender could grant up to 85% of the face value of such assets. While inventory, equipment and real estate can be pledged as collateral, expect to receive about 50% of their valuation because lenders consider these assets less liquid.
The Miller & Miller Law Firm seeks a loan to expand its operations. The company decides to pledge its accounts receivable balance as collateral.
Because of the high liquidity of accounts receivable balances, the lender agrees to advance 85% of the face value of these assets. On the balance sheet, the total of accounts receivables equals $105,000. This means the lender will loan $89,250 to the firm.
Here are 4 of the most common types of collateral used in asset based lending:
- Accounts Receivable: Any receivable due within 90 days may be pledged as collateral in an asset based loan. In this case, the size of the loan is proportionate to the outstanding receivables balance. The amount a lender will advance depends on many factors, including the collection period and the diversification of a business’s accounts. In most cases, advance rates on accounts receivables are set at 70%-90%.
- Inventory: If you’re a wholesaler, manufacturer or retailer, chances are you have a good amount of inventory on hand. That inventory can serve as collateral in an asset based loan. When assigning value, lenders will consider the nature of the commodity, margins and how quickly the inventory can be converted into saleable profits.
- Machinery and Equipment: Any machinery or equipment your business owns can be pledged as collateral. As these assets are not as easily converted to cash, they require special consideration. The borrowing base, therefore, widely varies. A lender will consider an asset’s useful life to determine value depreciation over time.
- Real Estate: Any real estate a business owns is eligible to secure an asset based loan. An independent appraiser will need to determine the property’s market value and any appreciation. If you’re still paying a mortgage on the property, you’ll need to have paid off a significant portion to pledge the property as collateral.
Asset Based Financing Basics
The application and approval process for an asset backed loan can be an extensive undertaking for both parties. In general, an ABL — more than other loan types — requires more paperwork and an involved due-diligence process, including an onsite audit. Before you apply, get a firm handle on the ABL finance consideration process to set your business up for success.
Gather Required Financial Documents
Asset backed lenders may request to see the following financial documentation.
- Balance Sheet: Your balance sheet offers a direct look into your assets, making it the single most important indicator of your business’s eligibility for asset based lending.
- Sales Forecast: Asset based lenders are more concerned with the future success of your business, rather than its history. If you have a well-researched sales forecast that tracks a growth trajectory, it might tip the scales in your favor.
- Banking Statements: Lenders will request to see at least 4 months’ worth of banking statements in your quest for an asset loan.
Before you apply, check each document for completeness and accuracy.
Prove the Value of Your Collateral
Depending on what you pledge as collateral, you’ll need to prepare the following statements to identify assets and their value when you apply for ABL finance.
- Accounts Receivable Aging Statement: If you plan to offer up your outstanding accounts receivables as collateral, you’ll need to prepare an aging statement that shows open invoices, their terms and the number of days these invoices are past due.
- Inventory List: If you seek to secure an asset loan backed by your inventory, a lender will request a detailed itemization, noting the location and resale value of each asset.
- Machinery and Equipment List: If you’re offering your equipment as collateral, you’ll need to detail each item’s purchase price, whether it was purchased new or used, its age, its location and its condition. You’ll also need to account for the depreciation of the equipment to estimate its current value; this may require an independent valuation from an appraiser.
Prepare for a Field Audit
As part of the due-diligence process, a lender will most likely conduct an onsite audit of your business. They’ll visit your space, audit your financials and examine any physical assets that will serve as collateral for the loan. If you’re approved, be aware that your lender may perform periodic audits of your collateral to continuously assess value.
Asset Based Financing Pros and Cons
Before you decide if ABL is right for you, consider the risks and benefits of asset based lending.
- Asset backed loans are more accessible than their cash flow counterparts
- A business that has assets on the balance sheet can put these investments to good use and secure additional funding for growth
- Not all assets qualify as collateral; for an optimal loan-to-value ratio, lenders look for high liquidity and low depreciation rates.
- Due to the thorough due-diligence process, obtaining an ABL takes time, so it’s not the best option if you need immediate access to capital
- There is the risk of losing your assets in the event of default