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Asset-based finance, which includes asset-based lending, factoring, purchase-order finance, warehouse receipts and leasing, differs from traditional debt finance, as a firm obtains funding based on the value of specific assets, rather than on its own credit standing. Working capital and term loans are thus secured by assets such as trade accounts receivable, inventory, machinery, equipment and real estate.
The key advantage of asset-based finance is that firms can access cash faster and under more flexible terms than they could have obtained from a conventional bank loan, regardless of their balance sheet position and future cash flow prospects. Furthermore, with asset-based finance, firms that lack credit history, face temporarily shortfalls or losses, or that need to accelerate cash flow to seize growth opportunities, can access working capital in a relatively short time. In addition, asset-based financiers do not generally require any personal guarantee from the entrepreneur, or that s/he give up equity.
Asset-based lending (ABL) is any form of lending secured by an asset. It is thus a transactions lending technology in which financial institutions address the problem of information asymmetry by focusing on a subset of the firms’ assets, as the primary source of repayment Typically, four types of asset classes are secured under ABL: accounts receivable, inventory, equipment and real estate.
The amount the firm can borrow depends on the appraised value of the selected assets, rather than on the overall creditworthiness of the firm, taking into account the ease to sell off the assets should the borrower be unable to generate cash to repay the loan. The amount of credit extended is linked to the liquidation value of the assets, which is estimated and monitored on the basis of hard data, often relying on industry-specific knowledge. Thus, monitoring and asset evaluation methodologies are of the utmost importance for this type of lending, which explains the historical use of ‘tangible’ assets to secure loans and, on the other hand, the limited exploitation of intangibles, such as trademarks, patents and copyright. However, as methodologies for evaluating intangible assets become more accepted, these assets can also increasingly be used as collateral.
Profile of firms
The use of assets to generate cash flow presents advantages for start-up companies, which have limited credit history, but also for fast-growing and cash-strapped firms, which can respond more rapidly to their short-term cash needs than through traditional debt channels.
ABL can serve in particular the needs of SMEs that are at a growth stage or that face seasonal build-up of inventory or receivables, whose value can be hardly reflected into traditional loans that have already been underwritten. In this regard, ABL allows for more flexibility than traditional lending in accessing a credit line, whose limit can be expanded quickly, as the value of the underlying assets change. For instance, in the case of a revolving credit facility secured by receivables, the outstanding loan amount may fluctuate on a daily base, providing a significant degree of flexibility to the borrower to finance evolving working capital needs.
The lender’s close monitoring of the secured assets’ value also implies that highly leveraged firms, or firms that have experienced recent losses, can obtain cash flow more easily than it is generally the case for conventional lending. This is because conventional lenders, which do not rely on specific assets to support their loan and are not closely monitoring any underlying collateral, typically require borrowers to maintain a conservative financial position over the loan terms. In this regard, through ABL, companies with strong accounts receivables and a solid base of creditworthy customers can overcome temporarily lending constraints or accelerate access to working capital. For this reason, ABL is usually considered to be a transitional source of financing, to weather temporarily cash flow shortfalls, when the firm does not qualify for traditional bank lending, or to take advantage of growth opportunities.
Features of asset-based loans
An asset based business line of credit is usually designed for the same purpose as a normal business line of credit – to allow the company to bridge itself between the timing of cash flows of payments it receives and expenses. The primary timing issue involves what are known as accounts receivables – the delay between selling something to a customer and receiving payment for it.
Factoring of receivables is a subset of asset-based lending (which uses inventory or other assets as collateral). The lender mitigates its risk by controlling who the company does business with to make sure that the company’s customers can actually pay.
Still another subset of a collateralize loan is a pledging of receivables and an assignment of receivables as collateral for the debt. In these instances, receivables are transferred to the lender when they are pledged as collateral. When the receivables are pledged as collateral, or assigned with the condition that the lender has recourse in the event the receivables are uncollectible, the receivables continue to be reported as the borrower’s asset on the borrower’s balance sheet and only a footnote is required to indicate these receivables are used as collateral for debt. The debt is reported as a liability on the borrower’s balance sheet and as an asset (specifically, a receivable) on the lender’s balance sheet.