What Is an Asset-Based Loan?
REtipster does not provide tax, investment, or financial advice. Always seek the help of a licensed financial professional before taking action.
- An asset-based loan is a loan or line of credit secured by a collateralized asset.
- Asset-based lenders may accept different types of collateral, from real estate to accounts receivable.
- These lenders look at the liquidation value of the collateral more than the credit score or rating of the borrower.
- They also set a base margin for the collateral’s value, influencing the loan amount or credit limit they can extend to the borrower.
How Asset-Based Loans Work
Asset-based loans are loans or lines of credit in which the borrower guarantees repayment by putting another asset on the line (known as using it as collateral). In asset-based finance, the borrower agrees that the lender may seize the eligible collateral when the borrower fails to pay the loan or violates the loan agreement terms.
A lender may accept different kinds of collateral based on their liquidation value. A mortgage is typically a form of asset-based lending, where the collateral is the borrower’s home. Other examples of collateral include assets on a company’s balance sheet, such as equipment, inventory, cash, stocks, bonds, insurance policies, and more.
Many asset-based loans are structured as revolving lines of credit. This setup enables the borrower to tap funds as needed continuously.
Underwriting Asset-Based Loans
A loan underwriter usually looks at the collateral’s value more than the borrower’s credit score. While all credit lines—including asset-based and traditional loans—may use credit scores to determine a borrower’s risk profile, it is not usually the deciding factor in granting an asset-based loan.
In assessing collateral, asset-based lenders extend their examination beyond historical financial performance. Lenders may conduct “hands-on” due diligence on the assets they can take as collateral. This collateral evaluation can also involve appraisals by a third party.
Their rule of thumb is that the more liquid the collateralized asset is, the less risk the loan carries.
For example, an asset-based loan with accounts receivable as collateral is less risky than a loan secured by real estate, which is illiquid. When determining collateral value this way, the lender may find it difficult to liquidate collateralized real estate should the borrower default.
BY THE NUMBERS: It takes an average of 71 days to sell a home in the United States, from listing to closing.
Source: US News & World Report
Determining Loan Amounts or Credit Limits
Asset-based lenders determine the loan amount or credit they can extend by calculating the “asset base” of their borrowers. To do this, the lenders usually do the steps below:
- Estimate the value of the collateral.
- Determine if there are encumbrances to the collateral.
- Inspect the borrower’s accounting books.
- Conduct an onsite visit to the borrower’s premises.
- Inspect the physical assets that may be involved.
- Interview the borrower’s employees relevant to the company’s assets.
In an asset-based line of credit, borrowers need to submit a weekly or monthly “borrowing base certificate,” which gauges the maximum credit limit the lenders can extend to the borrower.
Meanwhile, for an asset-based loan, the lender sets an advance rate. An advance rate is the maximum percentage of the collateral’s value that the lender can extend as a loan. For example, real estate worth $500,000 with an advance rate of 50% means the lender can extend $250,000 to the borrower.
Some common advance rates include:
- 50% of inventory.
- 60% of the liquidation value of machinery/equipment.
- 80% of current receivables.
Generally, the percentage of the secured assets’ value that borrowers can get is 50% of finished inventory and 70% to 80% of eligible receivables.
Who Takes Out an Asset-Based Loan?
In general, an asset-based loan is a product for business financing. One reason is that an asset-based loan requires special or high-value collateral that a typical individual can rarely produce.
Businesses resort to asset-based financing when they cannot access traditional fund-raising channels, such as the capital markets and mortgage-secured bank lending. The inability to get approved for unsecured loans may be due to a lack of credit rating or track record. Time pressure in obtaining a loan from a lender may also be a factor.
Companies that need immediate capital to finance certain projects may take out an asset-based loan. Funding for mergers, acquisitions, and inventory financing are examples of those needs.
Asset-based lending is also a remedy for the short-term financial needs of cash-strapped small businesses looking to quickly boost working capital.
Pros and Cons of an Asset-Based Loan
Like any financial product, an asset-based loan has advantages and disadvantages.
Asset-based lending is a growth sector in the U.S. financial industry because of the following advantages it provides borrowers:
- Fewer requirements. As a result, asset-based loan applications and funding go much faster than a traditional business loan.
- Flexible. Borrowers can use most asset-based loans for any purpose and at their discretion.
- Lower interest. Secured loans typically come with an interest rate lower than other term loans from a traditional lender. Note that this may depend on the type of collateral. For example, a hard money loan is asset-based financing with real estate as collateral, but it has a higher interest rate because of its illiquid nature.
There are drawbacks to asset-based loans that their borrowers must consider. Among these are the following:
- Risk of debt. Borrowers who continually collateralize their assets may end up with more debt than equity, especially if the value of their assets declines.
- Repossession. Defaulting on an asset-based loan can lead to the seizure of an asset vital to the operations of a business. For example, collateralized equipment that a lender seizes due to a loan default can disrupt the operations of the borrower’s business.
- Low collateral valuation. Lenders generally offer low valuation on assets for collateral in asset-based loans, compounded by low advance rates. A borrower using assets to increase their borrowing capacity may not be able to derive the funding needed.
- Other fees. Besides paying loan interest, borrowers have to cover certain charges. These can include due diligence fees, origination fees, and audit fees, among others, and can severely hamper a company’s cash flow.
- Baldwin, J.G. (2021.) Cash Flow vs. Asset-Based Business Lending: What’s the Difference? Investopedia. Retrieved from https://www.investopedia.com/articles/investing/091615/cash-flow-lending-vs-assetbased-lending
- Entrepreneur. (n.d.) The Ins and Outs of Asset-Based Loans. Retrieved from https://www.entrepreneur.com/article
- PNC Insights. (2020.) 4 Scenarios That Asset-Based Lending Can Solve for Today. Retrieved from https://www.pnc.com/insights/corporate-institutional/raise-capital/four-scenarios-that-asset-based-lending-can-solve-for-today
- Bank of America. (n.d.) Understanding Asset-Based Lending. Retrieved from https://business.bofa.com/en-us/content/what-is-asset-based-lending-how-it-works
- CFI. (n.d.) Asset-Based Lending. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/credit/asset-based-lending/
- Lions Financial. (n.d.) Should You Consider An Asset Based Loan For Your Business? Retrieved from https://lions.financial/should-you-consider-an-asset-based-loan-for-your-business/
- Kagan, J. (2020.) Asset-Based Lending. Investopedia. Retrieved from https://www.investopedia.com/terms/a/assetbasedlending
- Smith and Howard. (2016.) Fundamentals of Asset Based Lending. Retrieved from https://www.smith-howard.com/fundamentals-of-asset-based-lending/
- Fora Financial. (2021.) The Top Pros and Cons of Asset-Based Lending. Retrieved from https://www.forafinancial.com/blog/working-capital/asset-based-lending/
- Business Opportunities. (2021.) Asset Based Lending: Its Advantages and Disadvantages. Retrieved from https://www.business-opportunities.biz/2021/03/08/asset-based-lending-advantages-disadvantages/