Asset-based loan (ABL) is a catch-all term for a type of financing that allows you to finance corporate assets. These assets include accounts receivable, inventory, and equipment. ABLs secured by accounts receivable work like a revolving line of credit, with some differences. This article discusses how asset-based lines of credit work and how they are implemented. We cover:
- Who should consider an asset-based line of credit?
- How are they offered?
- How do asset-based credit lines work?
- Differences with conventional lines of credit
- Which option is better for your company?
1. Who should consider an asset-based line of credit?
An asset-based financing line of credit helps companies that are low on cash because their funds are tied to slow-paying invoices. The line of credit streamlines cash flow and provides funds to operate the business and invest in new opportunities.
These lines can work well for companies that have outgrown accounts receivable factoring but aren’t ready to qualify for a bank business line of credit. Companies should have a minimum of $350,000 in monthly sales, a good track record of operations, and clients with good business credit. Lastly, the company should have an established invoicing and collections process. This requirement is important since accounts receivable change regularly as new invoices are issued and old ones are paid.
2. How are the lines offered?
There are two ways to implement an asset-based line of credit. The option you ultimately select depends on your company’s size and strategy.
a) Ledgered line of credit
Smaller companies with a minimum of $350,000 of monthly revenue should consider a ledgered line of credit. This solution is also known as sales ledger financing. These lines tend to have more flexible qualification and operation requirements than other solutions.
b) Asset-based loans
Companies that invoice a minimum of $750,000/month with well-managed business processes should consider a conventional asset-based line of credit. These lines have more stringent qualification criteria than comparable sales ledger financing lines but are also cheaper.
3. How do asset-based lines of credit work?
Sales ledger financing and asset-based financing lines of credit work like a revolving line tied to your accounts receivable. Your company can draw funds from the line by submitting a request to the finance company. The line is repaid when your clients pay their invoices on their regular schedule.
These lines have a credit limit based on a percentage of your A/R. Most lines allow you to draw up to 85% of your eligible accounts receivable up to a certain dollar amount. Note that the actual percentage you can draw is based on your invoices’ credit quality, industry, and other criteria. Also, the credit limit can be increased easily if your company works with quality clients. Most increases are approved in a few days. Lines are usually priced using a “prime rate plus X%” model. Most finance companies calculate the financing cost based on monthly average usage, though the method varies by company.
The main difference between a sales ledger financing line and a conventional asset-based financing line of credit is in the documents you submit to draw funds. Sales ledger financing lines allow you to draw funds by presenting the finance company with a report listing the receivables you want to finance.
Asset-based financing lines of credit require that you present a borrowing certificate when you request to draw funds. This difference is significant. A borrowing base certificate is a streamlined financial report that calculates the amount of eligible receivables that can be financed. Your accounting system must be up-to-date before you can generate a valid borrowing certificate. Otherwise, your company and the lender will encounter problems when the team reconciles information. This is the main reason why these lines require that companies have well-established accounting processes.
4. Differences with conventional lines of credit
There are some important differences between asset-based financing lines of credit and conventional business lines of credit that business owners should keep in mind. Here are the four most important differences.
Bank lines of credit have stringent qualification requirements, which help reduce their risk. Consequently, lines are available only to clients with solid financial statements, a track record of performance, and substantial assets.
Qualifying for an asset-based financing line of credit is easier. The most important requirements to qualify are quality accounts receivable and a well-run business. These lines of credit can be used by companies that need to improve cash flow, are growing quickly, or are going through a turnaround.
Covenants are contractual requirements that your company must comply with to keep the line operational. Most financing products have covenants, though some solutions are more flexible than others. Bank lines of credit have strict covenants designed to limit the bank’s risk. Typical covenants include keeping a specified net worth, keeping financial ratios at certain levels, undergoing a monthly certification, and advising the lender of material changes. Asset-based lines of credit and sales ledger financing lines also have covenants. However, they allow clients more operational flexibility and are easier to comply with. Asset-based lenders also tend to be more lenient than banks when enforcing covenants.
c) Line increases
Increasing a business line of credit limit can be onerous since the request must go through the underwriting process. The process may require submitting additional financial information, posting additional collateral, and showing a track record of performance with the existing line.
Most line increases for an asset-based line of credit can be approved in a few days. The most important requirement is that your company have quality accounts receivable. There are cases, especially when the line reaches a substantial amount, where additional underwriting may be required. This process can usually be completed in about a week.
Bank lines of credit are cheaper than comparable asset-based financing lines of credit. This is because banks have lower costs of funds and work only with low-risk companies. Asset-based financing lines of credit are more expensive. This is because their cost of funds is high, they work with riskier transactions, and they offer a more flexible solution.
5. Which solution is better for your company?
The best way to determine which solution is better for your company is to have your finance team compare your options side-by-side. If your company’s situation is complex, consider working with a CPA experienced in financing. Every situation is different and must be evaluated accordingly. However, here are some guidelines that can help you in your decision-making process.
a) Do your profit margins support financing?
Assuming that the line of credit is used responsibly, most companies with a profit margin of 15% should be able to afford to get a line of credit. The situation becomes more complex if your profit margins are below 10% since the cost of financing could lead to margin degradation. Note that in some cases, the company may not be able afford to use financing, and any leverage could backfire. Bank lines of credit have the lowest costs and are usually the best option for companies with low margins. Companies with margins above 15% can usually use bank financing or an ABL.
b) What type of collateral do you have?
Most lenders will only provide a line of credit if the underlying asset securing the line is accounts receivable or inventory. The lender will offer a term loan if the company is financing other assets such as machinery or real estate. However, this is not a hard rule, and some lenders make exceptions.
c) Are your revenues stable?
Profitable companies that have reached maturity and have stable revenues are likely to qualify for a bank line of credit. In most cases, this is their best option. Companies growing quickly or with volatile revenues might be better off with an asset-based line of credit. These lines are better suited to manage volatility due to their flexibility.
d) Do you have well-established processes?
Commercial and asset-based financing lines of credit work best in companies with established financial management processes. Lines have covenants requiring the borrower to provide reports and financial measures regularly. Furthermore, some asset-based lines of credit also mandate that your accounting system is up to date because the lines require a borrowing certificate to draw funds. Less mature companies are likely better off using a sales ledger financing line.
e) Is your company in turnaround?
A line of credit may not be the best solution for a company undergoing a turnaround. You run the risk of unexpectedly falling out of covenant and getting into further financial problems. In most cases, sales ledger financing is a better option due to its easier qualification requirements and light covenants.
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