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There are a lot of misperceptions amongst CFOs and finance executives when it comes to asset-based lending. The greatest is that asset-based lending is a financing option of last resort - one that only " hopeless" companies that can't get a traditional bank loan or line of credit would look at.
With the economic decline and resulting credit crunch of the past few years, though, many companies that might have qualified for more traditional kinds of bank financing before have instead relied on asset-based lending. And to their shock, many have found asset-based lending to be a versatile and cost-effective financing tool.
What Asset-Based Lending Looks Like
A conventional asset-based lending situation frequently looks something like this: A business has stayed alive the recession and financial crisis by aggressively managing receivables and inventory and putting off replacement capital investment. Since the economy is in recovery (albeit a weak one), it needs to build up working capital to fund new receivables and inventory and fill new orders.
However, the business no longer qualifies for traditional bank loans or lines of credit due to high leverage, weakening collateral and/or extreme losses. From the bank's standpoint, the business is no longer creditworthy.
Even businesses with strong bank relationships can run afoul of loan covenants if they experience short-term losses, at times requiring banks to rescind on credit lines or drop credit line increases. A couple of bad quarters doesn't always indicate that a business finds themselves in trouble, but occasionally bankers' hands are tied and they're forced to make financing moves they might not have a few years ago, before the credit crunch switched the rules.
In situations like this, asset-based lending can offer the needed funds to really help businesses get through the storm. Companies with strong accounts receivable and a strong base of creditworthy customers often tend to be the most ideal candidates for accounts receivable financing advances.
With conventional bank loans, the banker is mainly worried about the borrower's projected cash flow, which will supply the funds to repay the loan. For this reason, bankers pay especially close attention to the borrower's balance sheet and income statement so as to gauge future cash flow. Asset-based lenders, however, are mainly worried about the performance of the assets being pledged as collateral, be they machinery, inventory or accounts receivable.
So before lending, asset-based lenders will typically have machinery or equipment independently valued by an appraiser. For inventory-backed loans, they commonly demand regular reports on inventory levels, together with liquidation valuations of the raw and finished inventory. And for loans backed by accounts receivable, they generally perform in-depth analyses of the eligibility of the collateral based on past due, concentrations and quality of the debtor base. But compared with banks, they typically do not place tenuous financial covenants on loans (e.g., a maximum debt-to-EBITDA ratio).
Asset-Based Lending: The Nuts and Bolts
Asset-based lending is effectively an umbrella term that includes several different varieties of loans that are secured by the assets of the borrower. The two main types of asset-based loans are factoring and accounts receivable (A/R) financing.
Receivable Factoring is the outright purchase of a business' outstanding accounts receivable by a commercial finance company (or factor). Normally, the factor will advance the business between 70 and 90 percent of the value of the receivable at the moment of purchase; the balance, less the factoring fee, is released when the invoice is collected. The invoice discounting fee typically ranges from 1.5-3 .0 percent, depending on such things as the collection risk and how many days the funds are in use.
Under a contract, the business can usually decide on which invoices to sell to the invoice factoring company. As soon as it purchases an invoice, the factoring company deals with the receivable until it is paid. The invoice factoring company will essentially become the business' defacto credit manager and A/R department, " completing credit checks, analyzing credit reports, and mailing and documenting invoices and payments.".
A/R financing, on the other hand, is more like a typical bank loan, with some chief differences. Even though bank loans may be secured by several kinds of collateral including equipment, real estate and/or the personal assets of the business owner, A/R financing is backed strictly by a pledge of the business' outstanding accounts receivable.
Under an A/R financing arrangement, a borrowing base is established at each draw, against which the business can borrow. A collateral management fee is charged against the outstanding amount, and when funds are advanced, interest is assessed only on the amount of money actually borrowed.
An invoice typically must be under 90 days old in order to count toward the borrowing base. There are usually other eligibility covenants like cross-aged, concentration limits on any one customer, and government or international customers, depending on the lender. In some cases, the underlying business (i.e., the end customer) must be viewed as creditworthy by the finance company if this customer constitutes a majority of the collateral
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Compared with a bank loan, the factor validation process can take short of a week. The secret to a quick approval process is a comprehensive and precise customer history. You can spare the factor hours, even days, when you are forthright and hones about the relevant information asked for. You should give specifics about your customers and the age of their accounts. Apart from a client profile, you may have to supply specifics regarding your business for example, a record of the clients, duration of time in business, monthly sales volume, and a depiction of your operation.
When accepted, you can expect to negotiate terms and conditions with the factor. The arrangement process takes a variety of parts of the agreement into things to consider. Say, if you wish to factor $10,000, you just cannot count on as great a deal as a business who wants to factor $500,000.
Through the negotiation process, you will become well aware of precisely what it costs to factor your accounts receivable. Depending on the discount schedule you negotiate, a factor may hold on to between 2-10 percent of the invoice's stated value as a charge. But, when weighed against the cost of lost business or giving up you business completely, the value of the cost associated with factoring diminishes greatly.
After you get an agreement with the receivable factoring company, the finance tires begin to spin. The receivable factoring company performs due diligence by analyzing your customers' credit and any liens placed against your company. The factoring company also validates the authenticity of your invoice right before purchasing your receivables and advancing funds to you.