Asset based financing has increased in popularity in recent years as companies look for alternatives to conventional bank financing. It’s a solution that provides flexible financing to companies that have cash flow shortages, usually due to growth. This article provides a general overview of asset based financing – how it works, its benefits, and its limitations. It helps you determine if asset based lending is the right solution for your company.
What is asset based financing?
Asset based financing is a form of financing that allows you to take a loan or a revolving line of credit using your assets as collateral. What makes asset based lending different from other products is that lenders make their financing determination based on the strength of your assets, rather than the strength of your company. The solution provides many of the benefits of bank financing, but it’s easier to obtain.
Most asset based loans are structured as revolving lines of credit, using receivables and other assets as collateral. In some instances, transactions can be structured as conventional term loans.
What are its advantages?
Asset based loans have a number of advantages that make them appealing to companies that need financing. Asset based loans:
- Can improve your cash flow quickly
- Offer flexibility
- Can be used for corporate turnarounds
- Are easier to get than other financing products
- Have fewer covenants than other products
- Can be cheaper than comparable solutions (e.g., factoring)
What are its disadvantages?
However, asset based loans have some limitations. The three most important limitations of the solution are:
- Payment must usually be handled via a lock box
- A large sample of invoices may be periodically verified
- Larger transactions may be subject to a lender audit
How is a transaction structured?
Transactions are usually structured as a revolving line of credit. The size of the line is dictated by your borrowing base, which is based on your eligible assets. Eligible assets include accounts receivable, inventory, machinery, property, and so on.
A lender does not allow you to borrow 100% of the asset. Instead, they put borrowing limits based on the asset type. Generally, accounts receivable has the highest limit at 80% -85%. Inventory, due to its liquidity risk, has limits closer to 50%. Note that lending limits are also determined by the quality of the underlying asset.
Once a borrowing base has been established, the client can submit a financing request to the lender. The finance company processes the request and remits the funds to client’s bank account. This payment gives the client immediate use of the funds. The transactions settle when the underlying assets convert to cash, usually when customers pay their invoices.
How are fees structured?
There are a number of ways to structure the fees for an asset based loan. Most revolving asset based loans that are backed by receivables use a two-fee model: the discount fee and the service fee. The discount fee is a one-time fee that is charged based on the gross value of the batch of invoices being financed.
The service fee, on the other hand, is a percentage that is charged against the actual utilized funds. It’s usually calculated daily, based on average outstanding funds, but charged monthly. The service fee is usually based on a percentage of the prime rate, known as “prime plus” structure. However, some companies prefer to use Libor as a benchmark.
Total fees are calculated by adding the discount fee and the service fee. Note that some lenders use other names for these fees though the transaction remains essentially the same.
These two fees are not the only fees that lender charge. Some lenders also charge audit fees, facility fees, management fees, and so on. However, the service fee and the discount fee represent the bulk of the transaction cost.
Similarities and differences with invoice factoring
In many respects, asset based financing is similar to invoice factoring. For example, both products let you borrow a percentage of your receivables. Also, both products use similar settlement methods. However, both solutions have some important differences.
Factoring lines are designed for small to mid-sized companies who have great assets but don’t have a long track record. Asset based loans, on the other hand, are offered only to mid-sized and larger companies who have assets but only have a moderate track record. In general, factoring clients have a higher risk and, therefore, have to:
- Pay a slightly higher fee
- Go through the notification process
- Have invoices verified directly
This does not mean that asset based lending is a better product. It is not. Asset based lending is simply better suited for some companies and for certain situations. You can learn more by reading “Asset Based Lending vs. Factoring“.
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