What is Asset Based Lending?
Asset-based lending refers to the loan provided by a financial institution to a business or a large corporation that is secured by asset collaterals including equipment, inventory, accounts receivable, property like real estate, and other balance sheet assets.
- Asset-based lending is a kind of mortgage where one keeps the asset as collateral to secure funds for its business and in the eventuality of non-payment of the loan or default by the borrower, the asset is liquidated and lender recoups most or all of its losses.
- It is often used as a revolving line of credit but they can be structured as term loans as well.
- It is generally used in the context of a business that is struggling with its working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)" requirements or some other cash flow demands. But the industry also caters to individuals and offers loans on assets secured as collateral like house, car, etc.
- Asset-based lending is size agnostic i.e company of all sizes – small, mid, and large having tangible assetsTangible AssetsAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets. For example, a company's land, as well as any structures erected on it, furniture, machinery, and equipment. use the asset-based loan for raising money rather than going to capital market by issuing debt or share because of high cost and time associated with them.
How Asset Based Lending Works?
The cash flow problem of companies may stem from various reasons like rapid growth, which requires additional capital apart from existing ones to invest and sustain business activities, or due to long debtor collection period or brief delay in payments it expects to receive which may create problems in payment of dues to its employees, creditors, and supplier of capital.
So if a business needs capital and it doesn’t have any history to show creditworthiness, nor does it have any guarantor or lacks cash flows to cover a loan, it can simply monetize its assets by keeping them collateral with the lender.
For Example – A real estate company is constructing building A, and it also won a bid to construct building B. So before it could receive cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. from selling an apartment in building A it has to construct building B.
Now, what can a company do to get the finances to construct building B? It will go to a bank, keep building or its equipment as collateral and obtain a loan. This is how the company gets its financing done in the absence of other options by converting illiquid assets into liquid one or sometimes pledging liquid assets like marketable securitiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company's balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it..
But one should keep in mind that interest rate and covenants of a loanCovenants Of A LoanCovenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements. are dependent on the quality and liquidity of the collateral. If the collateral is highly liquid marketable security (like a certificate of deposit, bonds, etc.) or short term investmentShort Term InvestmentShort term investments are those financial instruments which can be easily converted into cash in the next three to twelve months and are classified as current assets on the balance sheet. Most companies opt for such investments and park excess cash due to liquidity and solvency reasons., then a company could get a loan up to 70-80% of the face value of the security as it could be easily be converted into cash without selling it at a discount due to lack of buyer in case borrower defaults.
Whereas if the collateral is an illiquid asset like real estate asset or equipment like in our example mentioned above, then a company gets around half of the value of an asset due to illiquidity discount or due to depreciation of an asset.
One may ask a question as to why a company gets a loan of only 70-80% of even marketable securities despite the asset being liquid. The reason lies in the possibility of default of these securities and also includes costs of converting the collateral to cash in case borrower defaults.
Below are the advantages of Asset Based Lending.
- Helps in Monetizing Illiquid Assets – A business having fixed assets on a balance sheetFixed Assets On A Balance SheetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples. can be leveraged to access additional working capital. Whether it has inventory, equipment, or other illiquid assets, investments in them can be used to secure additional funds.
- Lower Cost – It has lower cost as compared to unsecured loans as assets pledged as collateral to secure a loan can be sold to recoup most of the losses in case borrower defaults.
- Easy to obtain – Unlike other conventional loans that require a lot of documentation, ABL can be easily obtained as the value of the collateral is the main criteria to be considered and as long as it fits the condition or criteria of the lender it is a hassle-free process.
- Provides Financial Stability – An asset-based loan provides a cushion in times of financial difficulty when a firm is struggling with finances and has nothing other than assets to offer as collateral, thereby restoring a stable financial state. This also prevents the firm from selling its assets at a discount for meeting its short term emergency needs and helps in converting an illiquid asset into liquid.
Disadvantages of Asset Based Lending
Below are the disadvantages of Asset Based Lending.
- Specific Criteria to be a Collateral – Not all assets qualify for collateral. The lender after its due diligence specifies which asset can be used as collateral and what amount of money can be raised based on the quality and riskiness of the collateral. Generally, asset having low depreciation and high liquidity is preferred.
- Risk of Losing Valuable Assets – If the company defaults on a loan, then the lender can seize the asset pledged as collateral and sell it to recover the money lent to the company. The borrower or the company should keep in mind as to what type and kind of asset is to be kept as collateral. If the borrower defaults and the asset kept as collateral is highly critical to ongoing business activity, then it will hamper its business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation. in a big way.
- Highly Risky Business – Asset-based lending can be very risky for the lender if risks are not properly assessed and possible eventualities are not factored in. Like what led to the 2008 US Subprime mortgage crisis? In simplest terms what happened was people were issued loans against houses and as the housing market rose, lenders became complacent because of high profits and issued loans to people having low creditworthiness. When the housing market crashed, the amount of loan issued against the houses was greater than the house value so the borrowers defaulted, which resulted in the bankruptcy of many large ABL and investment banks like Lehman brothers.
Asset-based lending is advantageous for both the lender and the borrower. The lender has an asset as collateral that could be sold to recover its amount lent to the borrower if it defaults.
The ABL enables the borrower to use this route to borrow money when other routes like selling bonds or unsecured loans are not possible as asset-based lenders are less concerned with business’s past cash flow, profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance., or even personal and business credit scores.
Asset-based loans are often confused with factoring. There are many similarities between them as both use receivables as collateral. However, there are differences. In factoring, the company doesn’t borrow money and sells its receivables at discount to improve its cash flow whereas, in ABL the company borrows money against the receivables as collateral.
This has been a guide to Asset Based Lending and its definition. Here we discuss how asset-based lending works along with advantages and disadvantages. You can learn more about financing from the following articles –