What Is Asset-Based Financing?
Asset-based financing (ABF) is a common method of debt finance that allows businesses to borrow funds against their corporate assets such as real estate, inventory, receivables and equipment. As long as these assets have value, ABF is more flexible than traditional bank financing.
How Does Asset-Based Financing Work?
Asset-based financing works like a line of credit or secured loan. How much a business can borrow depends on the total value of its assets, and this is expressed as a loan-to-value ratio (LTV), also called a borrowing base. On average, a business can borrow between 75 percent and 85 percent of an asset's worth.
Thus, the asset a business chooses determines what the average LTV is. For example, for loans backed by inventory or equipment, the LTV can be 50 percent or even less, as the asset’s value decreases with time. Accounts receivable, however, can have an LTV of 90 percent as their values are fixed. In an asset-based financing line of credit, the lender re-evaluates value of assets from time to time and adjusts the LTV accordingly.
Types of Asset-Based Financing
A diverse range of assets can be used as collateral for financing and they include the following:
- Accounts Receivable
Accounts receivable (A/R) is the practice of selling receivables to acquire funds for business operations. This is designed for businesses that sell services or products on credit to other businesses. The two forms of account receivable loans are factoring and invoice discounting.
In factoring, the factoring company operates on behalf of a business, collecting funds owned by customers and handling the sales ledger. It renders a large portion of the invoices (80 percent to 95 percent, approximately), where fund is available only when the invoices are paid. The relationship is always transparent and the customers will also be aware of the involvement of a factoring company.
Similar to factoring, invoice discounting is another exceptional ABF financing solution that turns out to be useful for large businesses. In this type:
- The invoice discounting firm monitors the growth of your business, as better sales would mean more funds.
- The business, however, administers the sales ledger; therefore, the customer never deals with invoice discounting firm, which stays a "secret partner.”
- Customers of the business are invoiced as usual, while the financing relationship remains only between the invoice discounting firm and the business.
Inventory financing provides businesses with an opportunity to use their inventory as collateral in order to get cash. This credit can be essential for buying additional inventory (for expanding the business) or helping the business through the seasonal fluctuations of cash flow. Inventory financing is ideal for small- to medium-size wholesalers and retailers.
- Real Estate
In real estate financing, almost any commercial property owned by a business can be used as a secured asset. In ABF, even the personal property/land or home of the business owner are taken into consideration. After getting the required financial documents, the lender does an in-depth cash flow analysis to evaluate the viability of the property as a form of asset. The rental income and other expenses like property taxes, maintenance and insurance are factors in calculating the net cash flow.
In addition to the common assets, others include:
The Advantages and Disadvantages of Asset-Based Financing
Asset-based finance’s benefits include:
- Competitive prices: A loan taken against collateral comes with competitive rates compared to unsecured loans.
- Credit does not count: Even when the lender verifies the borrower’s credit score, it does not have much weight as it would have in unsecured financing.
- No effect of seasonality: Distributors, manufacturers and associated businesses that have seasonal drops in the cash flow can take advantage of asset-based lending.
Asset-based finance’s disadvantages include:
- Not for emerging business: it is much easier for established businesses to meet the minimum borrowing requirements and show that their business financials good enough to be eligible for ABF.
- Higher fees: The business must cover cost of due diligence, which is costly.
- Long turnaround time: In some cases, this financing can take months; therefore, this is why it's not recommended for emergency funds.
Asset-based financing is a sound solution for businesses that are looking for flexibility, liquidity and a good cost of capital.