Definition: Asset-based finance is a specialized method of providing companies with working capital and term loans that use accounts receivable, inventory, machinery, equipment, or real estate as collateral. It is essentially any loan to a company that is secured by one of the company's assets.
In asset-based financing, the loan is secured by the assets of the borrower. Examples of assets that can be used to secure a loan include accounts receivable, inventory, marketable securities, and property, plant, and equipment (PP&E). Companies in return can get working capital, term loans, a revolving line of credit or to meet specific short-term cash needs. Asset-based funding is often used to pay for expenses when there are gaps in a company's cash flows, but it can also be used for startup company financing, refinancing existing loans, financing growth, mergers and acquisitions, and for management buy-outs (MBOs) and buy-ins (MBIs).
Loan Amount: Asset-based lending commonly uses the Loan-to-Value ratio (LTV) metrics to determine loan amount. The loan-to-value ratio depends on the type of asset – lenders are generally willing to offer a higher LTV ratio for more liquid assets. It is calculated as below:
Loan to Value Ratio = Loan Amount / Asset Value
Where: Loan Amount is the amount that the lender is willing to loan; and Asset Value is the market value of the asset being used as collateral for the loan.
Generally, the loan-to-value ratios can be as high as 95% for some marketable securities and as low as 40% for some illiquid assets. Due to the differences in financing products, lenders, business qualifications and the region where the business is set up, the interest rates for asset-based lending can vary widely.
Terms: Similar to interest rates, there’s no real consistency amongst asset-based lending terms. In fact, the terms associated with this type of financing vary largely based on the type of collateral that’s used to secure the loan. As an example, if accounts receivable is used to secure the loan, the terms are usually very short—based on the payment terms of the outstanding invoices. With machinery or equipment, on the other hand, the terms may be much longer—five or six years, up to the projected life of the piece of equipment.
Advantages and disadvantages Asset-based lending offers the following advantages to the borrower:
> Asset-based loans are easier and quicker to obtain than unsecured loans and lines of credit.
> Such loans generally include fewer covenants;
> Asset-based loans generally come with a lower interest rate compared to other funding options.
> Small businesses are able to get more cash faster than they could have got from a conventional bank loan.
> Factors and asset-based lenders proffer wide-ranging services together with accounts receivable processing, collections, and invoicing.
Following are the disadvantages of Asset Based Financing:
> 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, assets having low depreciation and high liquidity is preferred.
> There is a 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.
> In Asset Based Financing, interest rates are higher than what you’ll find with bank products since most asset-based lenders are alternative lenders. Interest rates greatly vary, and banks will sometimes include additional "audit" and due diligence fees to the overall cost of an asset-based loan.
What type of companies Asset-Based Financing
Asset-based loans are a great alternative for rapidly growing companies or those that are highly leveraged, undercapitalized, in turnaround or recovery cycles, or otherwise not bankable. Companies that have cash tied up in raw material and finished goods inventory or that experience seasonality or significant gaps in cash outlay and cash receipts are also good candidates for asset-based loans. For example, a manufacturing company that must purchase raw material prior to production but won’t receive payment until 30-90 days after production is completed will experience a negative cash flow for that project. An asset-based lender can finance the inventory, accounts receivable, unencumbered equipment, and real estate to help the manufacturer improve cash flow and working capital.
Asset-based loans can be used by companies in the following industries (and more):
> Business Services
Current Trends about ABF
According to Ed Gately, managing director of Mitsubishi UFJ Financial Group (MUFG), the world's fifth-largest financial institution by assets with approximately $2.7 trillion, the following trends are becoming increasingly apparent at what is now—10 years after the economic downturn of 2008–2009—a mature stage of the credit cycle:
1. Structures and advance rates: Structures continue to loosen and advance rates are becoming more aggressive as we near the peak of the credit cycle.
2. Commoditization: Certain loan structures are becoming commoditized in usage. This commoditization is notable among large corporate transactions led by private equity sponsors, who are replicating structures they’ve already deemed successful in previous transactions with similar companies.
3. More FILOs: Over the past few years, there has been a rise in the use of first-in, last-out (FILO) loans, which contain an advance against the most aggressive form of collateral. Common advance rates in asset-based lending are estimated at approximately 85%, whereas the advance rates of FILOs can reach 90% or even 95%. Moreover, higher advanced rates are increasingly being used for all different types of collateral that present greater risks.
4. Looser covenants: It is increasingly common to find more relaxed contractual covenants—even to the point where companies can be on the verge of bankruptcy before they ever default on an asset-based loan.
5. Aggressive lending in the middle market: Asset-based lending is becoming more aggressive among middle-market companies, many of which don’t have the depth of capital and resources to withstand an economic downturn as strongly as their larger counterparts.
Asset-based lending is becoming more aggressive among middle-market companies, many of which don’t have the depth of capital and resources to withstand an economic downturn as strongly as their larger counterparts.