If your business has assets and needs working capital to operate and grow, you may want to consider an asset-based loan or line of credit. As the loan’s value and security are derived from the collateral you pledge (and not your financial track record), it’s an especially useful form of financing if your business is young or you have less than stellar credit.

In this article, 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 needs.

The ABCs of ABLs (Asset-Based Lending)

As the name implies, asset-based lending is a form of business financing where 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.

In the unfortunate circumstance that a borrower defaults on a loan, the lender can seize and liquidate pledged assets to recoup losses.

Why Consider an Asset-Backed Loan?

Traditional small business loans are based first and foremost on cash flow. To qualify, your business must be established, demonstrate a history of profitability and boast a healthy credit score. But what if your small business fails to meet these qualifications? Enter asset-based lending. This form of financing is a solid alternative for young companies or entrepreneurs turned down by traditional lenders.

What Types of Assets Can Be Offered as Collateral?

As you can imagine, the list of assets you can offer as collateral is long and varied. If you own it and it can be sold, an asset may qualify as a form of collateral. But 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 like marketable securities (stocks and bonds) and accounts receivables. A lender may grant up to 85 percent of the face value of such assets. While inventory, equipment and real estate can be pledged as collateral, expect to receive only 50 percent of their valuation as lenders consider these assets less liquid.

Simply put, the more liquid the pledged asset, the higher the loan-to-value ratio. Let’s consider an example:

The Miller & Miller Law Firm seeks a loan to expand its operations. The company decides to pledge its accounts receivable balance as collateral. Due to its high liquidity, the lender aggress to advance 85 percent 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 four 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 term, collection period and the diversification of a business’s accounts. In most cases, advance rates on accounts receivables are set at 70 to 90 percent.
  • 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, varies widely. 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-backed loan. An independent appraiser will need to determine the property’s market value and any appreciations. It’s important to note, 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.

What to Expect When Applying for ABL Lending

The application and approval process for an asset-backed loan can be an extensive undertaking for both parties. In general, asset-based lending requires more paperwork and an involved due-diligence process, including an onsite audit. So before you apply, get a firm handle on the ABL consideration process to set your business up for success and as streamlined of a process as possible.

Gather Required Financial Documents

Asset-backed lenders may request to see the following financial documentation. Before you apply, check each for completeness and accuracy. This is a great time to make an appointment with your accountant to ensure all records are up to snuff.

  • Balance Sheet: Your balance sheet offers a direct look into the assets you own. For this reason, it is the single most important indicator of your business’s eligibility for ABL funding.
  • 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 may tip the scales in your favor.
  • Banking Statements: Lenders will request to see at least four months’ worth of banking statements.

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.

  • 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 a loan backed by your inventory, an ABL lender will request a detailed itemization, noting the location and resale value of each asset.
  • Machinery and Equipment List: If you are 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. Don’t be intimidated by the process as it’s par for the course in asset-backed financing. If you’re approved, be aware that your lender may perform periodic audits of your collateral to assess value continuously.

The Key Takeaways on Asset-Based Financing

Before you decide if asset-based lending is right for you, consider the risks and benefits to your small business.

On the upside, 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 to grow.

On the downside, not all assets qualify as collateral. For an optimal loan-to-value ratio, lenders look for high liquidity and low depreciation rates. And due to the thorough due-diligence process, obtaining an ABL loan does take time. For this reason, it’s not the best option for small business owners in need of immediate access to capital. And of course, there is the risk of losing your assets in the event of default. Therefore, prospective borrowers should always exercise discretion before using business collateral to secure their loan.

In short, asset-based lending is a viable option for the right kind of business in the right circumstance.