Everything You Need to Know About Asset-Backed Finance
Originally posted on https://ventsmagazine.com/2019/11/05/everything-you-need-to-know-about-asset-backed-finance/
Banks reject nearly three-quarters of the small business loan applications. Your odds of getting a business loan improve a little if you look beyond the bank. Even then, almost 60 percent of applications are turned down.
The rejection rates are disheartening, but they make sense. Small businesses and start-ups can be risky. Banks and other lenders may not want to extend a loan that won’t get paid back if the business folds.
Not being able to access capital puts business owners in a bind. One thing you can do is look at different types of funding. Asset backed finance is one option you may want to consider.
Defining Asset Backed Finance
Just what is asset-based financing? It’s any type of financing that’s backed by your company assets.
Essentially, you offer up an asset as collateral to secure the financing you need. If you happen to default on the loan, the lender takes control of the assets until you pay it back. This allows them to recoup some of the money.
You can think of your assets as an insurance policy for your lender. Having the assets there reduces their risk. In turn, they may be more willing to offer you the financing you need.
Asset-based financing is usually structured as revolving credit, like a line of credit. This gives your business access to ongoing working capital.
What Can be Used to Back a Loan?
Almost anything your business owns or buys can be used as collateral. Some common examples include:
- Equipment, such as company vehicles or commercial bakery equipment
- Invoices or outstanding customer payments
You may even be able to use trademarks or customer lists as collateral.
Determining the Borrowing Base
Usually, the lender will assess the value of the assets you want to use to secure the loan. They then extend a loan based on a percentage of that value. This is called the “borrowing base.”
Since asset-backed financing is structured as a revolving loan, your lender will assess your ledgers and the assets often. They’ll update the value of the loan based on that information.
Many lenders prefer to use accounts receivable to back your loan. That’s because accounts receivable convert to cash so easily. All it takes is a customer paying their bill.
As a result, most lenders will offer a higher percentage of the value of your accounts receivable. For example, you may be able to get a loan worth 75 or even 85 percent of your accounts receivable.
By contrast, equipment and inventory can be harder to convert to cash. Lenders offer lower percentages on these types of assets.
You may be able to use real estate or other assets to back your loan. Just remember that the harder it is to convert to cash, the less your lender will offer.
ABL vs. Invoice Factoring
Asset-based financing looks like another product called invoice factoring. The two are quite different.
Invoice factoring is usually used by businesses to collect on accounts in arrears. Overdue invoices or non-paying customer accounts are auctioned off on an individual basis. The buyer pays the company part of the value of the account.
Invoice factoring is part of the collections process. An asset-based loan is not. Rather, your lender assesses your accounts receivable and offers you a loan based on the value.
This includes all accounts, and asset-backed lenders like to see plenty of accounts that pay on time. That’s quite different from invoice factoring, where the accounts are less likely to pay.
Who Benefits from Asset-Backed Financing?
Almost any business can benefit from asset-based lending. It’s especially helpful for businesses that need access to capital to fuel their growth. A lack of access can cause cash flow issues and even limit a business’s growth.
It’s easy to see how this happens when traditional lenders like banks won’t extend financing. A business suddenly has a large order come in and needs to buy more inventory to meet demand. Without access to capital, they can’t buy the materials, and the customer’s order goes unfulfilled.
Repeat this process a few times, and you’ll end up with angry customers looking elsewhere.
Service-based businesses may also run into issues with cash flow as they grow. Suppose you decide to expand your popular restaurant to a second location. You need to hire on extra servers and chefs to staff the new location before it will ever turn a profit.
You have to pay your staff regularly, or you’ll find yourself short-staffed on a frequent basis. In turn, your customers wait a long time to receive their orders. Even if the food is fantastic, the lackluster service will likely convince hungry diners to stay away.
You may even need funds to help you manage seasonal costs. A retail store needs more hands on deck for the holiday season at the end of the year. A hotel, by contrast, will want to have more people on staff during the height of tourist season in the summer.
Even something as simple as making sure your floors are cleaned more often in the winter can strain your finances. With asset-based financing, you’ll be able to weather the ups and downs.
It’s important to consider how much you’ll need on a loan before you apply for one. Most asset-based lenders will make their own assessment of what they can offer. They may turn down your application if they think you’re asking for too much.
An asset-based loan is intended for ongoing use, often for regular business expenses. You may use it to make sure payroll is doled out on time, or to make inventory purchases when you need to.
For that reason, the value of asset-based loans usually starts around $250,000. It can range into the millions.
If you need less than that amount, you may want to consider a different type of financing. If the money is earmarked for a specific purchase, you may want to think about an installment loan.
If you looked at your invoices and saw that 85 percent would be less than $250,000, consider another asset. If you’re still not meeting the requirements, you may want to consider an alternative lender.
Benefits of Asset-Backed Finance
There are two major benefits of asset-backed financing.
First, it’s an option to consider when you can’t qualify for an unsecured line of credit or a traditional loan. Next, it can be a smart way to finance growth.
Asset-based lending can help you smooth out any cash flow issues you’re experiencing. Cash flow issues are responsible for 80 percent of business failures, so you want to solve this business problem.
Asset-backed financing also encourages you to improve your accounts receivable processes.
This type of loan also offers your business more flexibility than traditional loans. You only use what you need, and any cash you’re not using can be used to pay down the loan and make more funds available. There may also be fewer restrictions on what you do with the funds.
They also provide a cushion for your business, and they can reduce your debt. Finally, it’s usually much faster and easier to get an asset-backed loan.
Are There Any Drawbacks?
There are two potential drawbacks of asset-based financing.
First, the interest rates may be higher than conventional loans. A higher interest rate is another insurance policy for the lender. There may also be extra fees, such as auditing fees for the lender performing due diligence on your ledgers.
More important, there is the risk of the lender seizing your assets if you don’t pay. Losing assets could mean you’re unable to fill customer orders. It also makes it more difficult to get financing in the future.
Lenders may also disagree on what is an “eligible” asset. For example, they may deem sales to individuals or small businesses as ineligible.
How to Qualify
The first step in getting asset-based financing is finding a lender willing to extend a loan to you. You’ll need to prepare your financial statements and review your customer list.
The good news is that if your financial statements are in good order and your customers pay their bills on time, you’ll likely qualify for a loan.
You may want to work through an asset-based lending broker to find lenders. This is a smart move if you’re a young business, as start-ups often seem riskier to lenders.
Solve Cash Flow Issues with the Right Financing
The right financial backing can make or break a business. Asset-backed finance is a good option for many, and it could be right for your business.
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