Asset Based Lending

Definition of Asset Based Lending

The term “asset based lending” refers to a particular type of business lending in which the loan agreement is secured by collateral. An asset based lending may be secured by equipment, inventory, accounts receivable, or properties in the name of the borrower. It is also popularly known as asset based financing.

 

Features of Asset Based Lending

• The lending is done against the borrower’s assets, which are known as collateral.
• Liquid collaterals are preferable to illiquid assets, such as equipment.
• It usually attracts lower interest rates as in the event of a default the lender can recover the outstanding amount by liquidating the borrower’s assets.
• While large enterprises use it for financing strategic projects, small to medium business owners use it to cover short-term cash flow demands.

How Does Asset Based Lending Work?

Since asset based lending is secured by the borrower’s assets, it is considered to be less risky as compared to unsecured lending and, hence, it attracts a lower interest rate. Further, the liquidity of the collateral also influences the interest rate – the higher the liquidity of the asset, the lower the interest rate charged.

There is a term called loan-to-value ratio or LTV ratio. The LTV ratio states how much loan the borrower can avail against the asset offered as collateral. The lenders are usually willing to offer a higher LTV ratio for more liquid assets. Mathematically, the LTV ratio is represented as:

LTV Ratio = Loan Amount / Asset Value

Example

Let us assume that XYZ Inc. has applied for an asset based loan worth $50,000 to cover short-term business requirements. The lender has offered to provide the loan as per the following LTV ratios:

• Machinery & equipment: 40%
• Inventory: 60%
• Marketable securities: 80%

The borrower has the option to offer any one of the following as the collateral for the loan:

• Machinery & equipment valued at $100,000
• Inventory valued at $90,000
• Marketable securities valued at $60,000

Determine which asset the borrower should offer to secure the loan.

The maximum loan amount that can be secured by each asset can be calculated based on the LTV ratio and asset value as,

Machinery & Equipment is calculated as

Machinery & Equipment = LTV ratio * Asset Value

Machinery & Equipment = 40% * $100,000 = $40,000

• Inventory = 60% * $90,000 = $54,000
• Marketable securities = 80% * $60,000 = $48,000

Therefore, XYZ Inc. should use inventory to secure the asset based loan of $50,000.

Usage of Asset Based Lending

It is used by companies for various purposes. Some of the major usages are as follows:

• It is usually used by companies only after they have exhausted all other options of raising capital for project financing, such as mergers & acquisitions, debt purchasing, etc.
• Various lenders use asset based lending for curating structured and leveraged financial services.
• Many lenders also offer short-term loans against luxury assets, which may include luxury watches, vintage cars, wine collections, etc.

Difference between Factoring and Asset Based Lending

Factoring of account receivables and asset based lending is often confused to be similar. But there are some factors that differentiate factoring from asset based lending:

• In factoring, the company sells its receivables at a discount. On the other hand, asset based lending, the company borrows money against its receivables as collateral.
• Factoring is usually used for funding small or start-up companies that don’t qualify for traditional bank financing. On the other hand, asset based lending is generally used by larger and more established companies.
• In factoring, there are no monthly payments, and factoring of invoices takes place with each sales transaction. On the other hand, asset based lending involves scheduled loan payments.
• The factoring fee is expressed as a percentage of the invoice value. On the other hand, asset based lending is priced as an annual percentage rate charged on the loan amount.
• The approval process for factoring is faster as it only involves reviewing the credit ratings of the borrower and its debtors, which only takes a few days. On the other hand, asset based lending requires valuation of the collaterals, which takes several days or even weeks.

Advantages

• A business can utilize available assets to access additional business funding.
• It is offered at a lower interest rate as compared to an unsecured loan.
• It requires very little documentation as the asset value of the collateral remains the main criterion.
• It provides a cushion during times of financial stress when no other fundraising options are available.

Disadvantages

• All assets don’t qualify for collateral. Lenders usually prefer assets with low depreciation and high liquidity.
• There is a risk of losing valuable assets as the lender has the right to confiscate the asset pledged as collateral and sell it to recover the loan amount if the borrower defaults.

Key Takeaways

• Asset based lending is a win-win situation for the borrower and the lender. The borrower gets the loan at a lower interest rate while the lender has the collateral that could be liquidated if the borrower defaults.
• A borrower resorts to asset based lending only when other routes have been exhausted. The lender of an asset based loan is only in the asset value of the collateral and is less concerned with the borrower’s cash flow in the past, profitability, etc.
• People usually confuse factoring as both use receivables as collateral. However, a borrower sells its receivables at a discount in the case of factoring, whereas a borrower borrows money against its receivables as collateral in the case of asset based lending.

Recommended Articles

This is a guide to Asset Based Lending. Here we discuss the introduction and how does asset based lending work. along with advantages and disadvantages. You may also have a look at the following articles to learn more –

1. Non-Recourse Loan
2. Non-Conforming Loan
3. Predatory Lending
4. Peer to Peer Lending