Summary: An asset-based line of credit is a specialized type of asset-based loan. It provides a revolving line of financing that must be secured by Accounts Receivable (A/R). Some lines can also finance Inventory as long as the A/R is included in the transaction.
These lines are often used by small and mid-sized companies that need more flexibility than banks can provide. The article explains how these lines are implemented and structured. We also discuss their qualification criteria. We cover the following:
- What is an asset-based line of credit?
- Who should consider an asset-based line of credit?
- How are these lines structured?
- Benefits and limitations
- Which solution is best for you?
- Alternatives for smaller companies
1. What is an asset-based line of credit?
An asset-based line of credit is a generic term for a specialized type of asset-based loan (ABL). These lines finance a company’s Accounts Receivable (A/R) to provide an ongoing revolving line.
Your company can draw funds from the line as needed, up to the limit. They are paid back as your clients pay their invoices in 30 to 60 days.
Some ABL lines of credit also allow you to finance your Inventory, provided you also finance your A/R. However, only some providers offer this.
There are two solutions that provide a line of credit secured by A/R: a ledgered line of credit or a conventional asset-based loan. Which option works best for your company depends on its size, needs, operations, and collateral.
2. Who should consider an asset-based line of credit?
Asset-based lines of credit are well suited for small and middle-market companies that need financing but are not a good fit for bank financing. Usually, these companies meet some or all of the following criteria.
a) Have strong Accounts Receivable
Asset-based lines of credit usually rely on Accounts Receivable as the main collateral supporting the transaction. Consequently, your clients must have strong business credit and pay their invoices in 30 to 80 days.
b) Growing quickly
This type of financing is well-suited for companies that are growing quickly. Asset-based lines of credit adapt to growing revenues, ensuring you have better liquidity. Line increases can be done quickly and with minimal additional underwriting.
c) Need simpler covenants/compliance
Asset-based lines of credit typically have fewer covenants than bank lines of comparable size. Additionally, their covenants are more flexible. This simplifies compliance and usage.
d) Distressed and special assets
Most ABL lines of credit are available to distressed companies as long as they meet the qualification and underwriting criteria. They are also available to companies that have been referred to their bank’s Special Assets department.
e) Lower-middle market or larger
These lines are typically used by lower middle-market companies. The lines have minimum A/R requirements, which vary based on the type of line you use.
3. How are the lines structured?
There are two ways to implement an asset-based line of credit. The option you ultimately use depends on your company’s size, requirements, challenges, and strategy.
a) Asset-based loans
Companies with well-managed business processes that invoice at least $750,000/month should consider a conventional asset-based loan. These lines offer the most flexibility and allow you to finance your A/R and Inventory.
These lines typically use a borrowing certificate to determine the availability of funds for a draw. Consequently, your company must have an up-to-date accounting system and a reliable A/R management department.
Companies that want to finance Inventory need to have marketable Inventory. Additionally, they should have a perpetual inventory management system in place.
Asset-based lines of credit typically allow you to finance around 85% of your eligible A/R. This percentage varies based on industry, needs, and risk profile.
Inventory lines allow you to finance around 50% of their appraised value. Every lender uses their own appraisal methods, though most use the Net Orderly Liquidation Value (NOLV).
Read “What is an asset-based loan (ABL)? How does it work?” to learn more.
b) Ledgered line of credit
Smaller companies with a minimum of $350,000 monthly revenue should consider a ledgered line of credit. This solution is also known as sales ledger financing.
Sales ledger financing offers many benefits of a conventional ABL line of credit but with simpler qualifications and usage. These lines only finance A/R and typically provide up to 85% of eligible receivables.
Most ledgered lines don’t require a borrowing certificate. Instead, you send a listing of receivables to schedule a draw. They also have fewer covenants than conventional ABls and simpler qualification requirements.
4. Benefits and limitations
Asset-based loans and sales ledger financing share similar benefits and limitations when compared to a bank line of credit. However, there are important differences between both solutions.
a) Benefits
The main benefits of a ledgered line are its flexibility and simpler qualification requirements. This is important for companies that have outgrown smaller financing solutions but aren’t ready for an ABL.
On the other hand, the main benefits of an ABL line of credit are its cost-effectiveness and the support of mixed collateral. This is important for larger companies that cannot meet a bank’s stringent covenants.
b) Limitations
The main limitation of both solutions is cost. Asset-based loans and ledgered lines of credit are more expensive than conventional bank financing. Note that ledgered lines are also slightly more expensive than ABLs.
Additionally, these lines are offered only to companies that meet certain size criteria. They are not an option for small businesses that invoice less than $250,000/month. In the last section, we cover an alternative that works for small companies.
5. Which solution is best for you?
In our experience, most companies with monthly revenues between $250,000 – $750,000 should consider a ledgered line. The simpler covenants and ease of use are worth the slightly higher price.
Larger companies or companies that need to finance Inventory should consider an ABL line of credit. These offer the option to leverage Inventory and slightly lower costs.
Ultimately, which solution will work best for your company depends on your company’s situation, financials, risk profile, and strategy.
6. Alternatives for smaller companies
Small business owners often face challenges when looking for an asset-based line of credit. Most providers only focus on larger companies.
Small businesses can get benefits similar to those of an ABL line of credit by using invoice factoring. This solution allows you to leverage your Accounts Receivable and provides advances as high as 90%.
These lines have simpler qualification requirements and can be deployed quickly. However, they have higher rates and tighter controls.
Companies should use factoring as a stepping stone to a more cost-effective solution like a ledgered line. Eventually, they should consider bank financing, which will always be the most cost-effective. Read “How does factoring work?” to learn more.
Need financing?
We are a leading provider of asset-based lending. For a quote, please fill out this form or call us toll-free at (877) 400 3258 to speak with a representative.