Summary: An asset-based loan (ABL) is a type of business financing secured by a company’s assets. They improve liquidity and can be used to cover expenses or to invest in company growth.
Asset-based loans can be structured as a term loan, revolving line, or a combination of both. The loan structure depends on the collateral backing the transaction.
This article explains how asset-based loans work and their qualification requirements. We cover the following:
- How do asset-based loans work?
- Advantages and disadvantages
- Who qualifies for asset-based lending?
- What assets can be used as collateral?
- How does due diligence work?
- How much do asset-based loans cost?
- Alternative solutions
1. How do asset-based loans work?
An asset-based loan is a type of financing that allows companies to leverage some of their existing assets. These loans are well suited for small and middle-market companies and provide funds for ongoing and other business expenses.
Asset-based loans can be implemented as conventional term loans, revolving lines of credit, or a combination of both. The loan structure usually depends on the underlying assets that serve as collateral for the loan.
a) Machinery and equipment
ABLs secured by machinery, equipment, or corporate real estate are usually structured as term loans. The lender lets the client borrow a percentage of the asset’s appraised value.
The percentage that can be leveraged depends on the type of asset and its market value. Loans are amortized and paid over several years.
b) Accounts receivable and inventory
Transactions secured by receivables or inventory are usually structured as revolving lines of credit. These lines allow clients to draw funds on a percentage of their accounts receivable up to a certain limit. The lines are paid back as your clients pay their invoices on their usual terms.
The percentage and credit limit are determined by your needs, volume, industry, and risk. Most lenders allow clients to borrow up to 85% of their eligible accounts receivable, though that amount varies by transaction.
Clients draw funds from the line using a borrowing certificate. The borrowing certificate is a document (e.g., a spreadsheet) that enables the client to calculate the borrowing base by entering some financial information.
2. Advantages and disadvantages
While ABLs are flexible and have several advantages, they won’t work for every business. They require the companies to have assets in addition to strong accounts receivable.
Advantages
Assed-based loans have five primary advantages compared to bank financing and similar options. They work well for companies requiring more flexibility than a conventional lender can provide.
a) Simpler requirements than bank financing
Asset-based financing is an excellent option for companies that cannot meet bank lending criteria. The qualification and monitoring requirements are simpler, which makes them easier to manage and maintain.
b) Available to small middle-market companies
Asset-based loans can be a great option for small middle-market companies that have outgrown their incumbent small business financing facility. They work well for companies with mixed collateral.
c) Available for turnarounds
Asset-based loans can be used by distressed companies or companies whose loans have been assigned to special assets. The facility can provide benefits similar to those of a bank facility but with fewer compliance requirements.
d) Flexible covenants
ABLs typically have flexible covenants. These covenants can often accommodate companies with seasonal revenues and similar challenges.
e) Supports different collateral types
These lines allow your company to leverage several types of collateral. This gives them flexibility over other options that focus only on a single collateral type (e.g., A/R only).
Disadvantages
Asset-based loans have three main disadvantages over other alternatives.
a) Due diligence cost
The due diligence cost for asset-based financing is typically higher than some alternatives. This cost is noticeable for companies that only wish to finance their receivables and may be better served with a ledgered line (See section 7).
b) Line Monitoring
Asset-based financing lines typically require ongoing collateral monitoring. The type of monitoring depends on the collateral used to secure the line.
c) More expensive than bank financing
Asset-based lines are more expensive than comparable bank financing. The higher cost is a trade-off that comes from the line’s flexibility and lighter covenants.
3. Qualification requirements
Asset-based loans are offered to companies with yearly revenues of $12 million or more. Most asset-based loans have a minimum utilization requirement of $750,000/month, though this varies.
Clients should have a solid client base and be able to provide accurate financial statements. Most companies that use ABLs are stable businesses that are growing. However, asset-based loans can be used by companies in turnaround mode or referred to their lender’s Special Assets department. Read “Asset-based loan qualification requirements” to learn more.
4. What assets can be used as collateral?
Companies can leverage most of their conventional marketable assets as long as the value can be appraised easily. Common assets include:
- Accounts receivable
- Inventory
- Machinery
- Equipment
- Real estate (e.g., company’s office or plant)
Each ABL provider has its own set of competencies and preferences. Many lenders prefer accounts receivable due to their quick turnaround and ease of appraisal. However, some lenders are comfortable financing a mix of assets.
5. How does the due diligence process work?
The due diligence process enables the lender to determine the opportunity’s viability and the terms to offer. The process varies based on the transaction’s size, industry, and complexity.
During due diligence, the lender reviews your company’s financial records and appraises the company’s assets. A client’s financial statements must be up-to-date and reliable. Additionally, the client’s tax returns must also be up to date.
The due diligence process typically requires site visits. Lenders often send appraisers to evaluate collateral at the client’s location. Note that clients must cover the due diligence cost, which varies by company and transaction.
6. What is the cost of an ABL?
Most asset-based loans have two costs. The first cost is the due diligence to underwrite the transaction. This cost must be paid when setting the initial loan. However, some loan maintenance items may also be applicable during loan operations. The second cost is the cost of using the ABL.
a) Due diligence cost
The due diligence cost covers all the expenses associated with underwriting the asset-based loan. There is no set cost per se since it varies based on the specific details of the transaction.
Larger and more complex transactions are more expensive to underwrite than smaller, simpler ones. Due diligence costs cover expenses such as:
- Site visits
- Financial reviews
- Asset appraisals
- Legal expenses
b) Financing cost
Most financing costs are based on the prime rate and use a “prime plus X%” model. Most term loans against machinery or equipment use an annual percentage rate (APR). Lines of credit secured by accounts receivable or inventory usually charge a rate based on utilization.
Some lenders also have additional fees to cover maintenance and management.
7. Other options
Companies that only want to finance their accounts receivable or cannot qualify for an asset based loan should consider the following options.
a) Sales ledger financing
A ledgered line (e.g., sales ledger financing) works like an ABL line of credit secured by accounts receivable. However, they have simpler qualification requirements and are easier to operate.
Lines can start at a minimum utilization of $250,000 and don’t need a borrowing certificate to draw funds. Instead, the company can present the list of the invoices they want to finance.
Ledgered lines of credit are slightly more expensive than an ABL of comparable size but are much simpler to operate. This advantage makes sales ledger financing an excellent alternative for small companies that cannot qualify for a conventional ABL or prefer a simpler alternative. Read “What is a ledgered line of credit? How does it work?” to learn more.
b) Accounts receivable factoring
Companies that cannot qualify for sales ledger financing should consider using accounts receivable factoring. Factoring allows companies to finance their invoices, much like sales ledger financing.
This alternative has simple qualification criteria and minimal covenants. Lines are also very flexible, and companies can quickly increase credit limits. Furthermore, factoring can be used by companies with some problems and are in the midst of a turnaround.
There are some differences between factoring and ABLs that managers should keep in mind. In general, factoring companies need additional documentation and controls during funding since the transaction works by selling your invoices to the factor. Also, factoring lines are more expensive than comparable sales ledger financing lines. To learn more, read “What is Accounts Receivable Factoring?“
Need asset based financing?
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