Businesses large and small have been affected by recent economic challenges caused by the financial crisis and the resulting tightening of lending standards. Many companies are getting rejected for unsecured loans that they would have qualified for just a few short years ago.
Asset-based lending (“ABL”), also known as secured lending, was once considered a last-resort finance option; however, it is now the most common form of lending on the market. This type of lending is usually done when the normal routes of raising funds, such as capital markets (selling bonds), normal unsecured or mortgage-secured bank lending is not possible or the company has a need for immediate capital for project financing (such as inventory purchases, mergers, acquisitions and debt purchasing).
In contrast to ABL, “cash flow” lending are loans repaid through the business’ cash flow and are not related to any specific collateral. Consumers include retailers, wholesalers, producers, distributors, public companies and private firms to list a few.
ABL has become a popular choice for companies that lack the credit rating, track record, time and/or ability to pursue more traditional capital sources. ABL is also a way for rapidly growing, cash strapped companies to meet their short-term cash needs. Small businesses have fueled the growth of the asset-based financial services industry in recent years. Asset based loans use a company’s liquid assets rather than only a credit score, to determine whether they are going to lend to them. Credit scores are still obtained, but they are not the ultimate and definitive deciding factor with asset-based lending.
The four major ABL asset classes are accounts receivable, inventory, equipment and real estate. More recently, intangible assets such as trademarks and customer lists have also been used as collateral for asset-based loans.
An important characteristic distinguishing ABL is dominion, or the concept of controlling cash. Asset-based lenders require the borrower to have the payments on its invoices remitted directly to a bank account controlled by the lender. This “blocked” account is swept daily so the excess funds can be moved to an operating account used by the borrower. A modified version of this procedure, called springing dominium, has money deposited into the borrower’s operating account, and then the funds necessary to pay down the line are transferred to the lender or to a blocked account.
Asset-based lenders establish a formula by which advances under the line of credit can be taken. For example, a borrower might finance 85% of eligible accounts receivable and 80% of net orderly liquidating value (“NOLV”) of the inventory. The lender audits the borrower’s assets daily to monitor and secure the performance of the loan, which is directly connected to the underlying collateral. By comparison, cash flow lenders generally are satisfied with monthly reporting.
A non-asset based line of credit will have a credit limit set on account opening by the accounts receivable size, to ensure that it is used for the correct purpose. An asset-based line of credit however, will typically have a revolving credit limit that fluctuates based on the company’s actual accounts receivables balances. This requires the lender to monitor and audit the company to evaluate the accounts receivables size, but allows for larger limits of credits and can allow companies to borrow that normally would not be able to. Asset-based loans range from 6 months to 3 years or more.
Why Choose an Asset-Based Line Over a Cash Flow Line?
A principal reason is the borrower’s creditworthiness. Since middle and upper market cash flow lenders are not relying on specific assets to support their loan, and are not closely monitoring any underlying collateral, they require a borrower to maintain a conservative financial position. To illustrate, a typical commercial bank may require the ratio of total liabilities to tangible net worth be less than 4:1 and the amount of free cash flow needed to pay interest and principal, (or “debt service”), to exceed a ratio of 1.25:1 or 1.5:1. Thus, a creditworthy company with positive cash flow and leverage which exceeds 4:1 will not qualify for cash flow based loans but can likely obtain necessary working capital financing by utilizing ABL.
Another example of why creditworthy borrowers choose an ABL arrangement over the traditional commercial bank lines of credit relates to the application of the credit limit set by the lender. In a traditional cash flow based line of credit, an annual fixed amount is established, based on an analysis of the balance sheet, combined with the cash flow generated by the company. Once the credit limit is set, and provided no default has occurred, the borrower has the right to draw down up to the full amount of the line. However, this can limit a borrower facing a seasonal build-up of inventory or receivables, or one in a high growth mode. With ABL, a line is set, but the borrower has more flexibility to draw down on the line, or more quickly obtain an increase in the line, since the borrowings are formula based and directly related to the underlying assets established for the borrowing base. The borrowing base formula defines which assets will be loaned against, the minimum acceptable quality of those assets, and the amount of required loan to the value of the collateral (“LTV”) to lower the risks involved in making the loan.
Asset-Based Lenders: Finance Company vs. Bank
Working capital financing is also provided by non-commercial bank asset-based lenders and finance companies. These lenders distinguish themselves by accepting a greater degree of credit risk. Specifically, banks’ ABL divisions generally require positive EBITDA or Free Cash Flow, (EBITDA less capital expenditures and debt service), which represents payments of principal and interest on the borrowers total outstanding debt. Finance companies often do not look for positive EBITDA, but rather to the collateral and the LTV and/or side collateral provided to the lender.
Understandably, the cost to the borrower from a finance company is expected to be higher to reflect the increased credit risk underwritten. Asset-based loans are typically for companies with less-than-perfect credit. Interest rates and fees for these types of loans have fallen in recent years due to intense competition, but generally they are higher than the traditional bank loans. As with commercial lending, rates are negotiable. Lenders will look at the credit record, length of business operations and liquidity of the pledged assets.
Rates of interest on asset-based lending are lower than those of unsecured loans. This is because, the lender has the power to take over the assets of the borrower if the borrower defaults the loan payment. However, the borrowers are more prone to lose their valuable assets in the eventuality of nonpayment.
Receivables are the asset-based lender’s favorite type of collateral because of their liquidity and predefined value. Receivables originate at an agreed-upon amount and are typically collected in a matter of days. A borrowing base may permit advances up to 80% of certain accounts receivable.
Inventory is not as popular a form of collateral. The lender retains a larger LTV when lending against inventory because inventory has neither the stable value nor the liquidity of accounts receivable. Inventory must first be converted into cash, and several features inherent in inventory, such as LIFO and FIFO and, market/liquidation value versus original cost, make it difficult to determine its value and quality. A lender might permit borrowings of up to 40% of certain inventory.
Longer lived assets such as equipment and real estate offer the opportunity to be financed over a period of time more in keeping with the useful life of that asset and, therefore, generally are the basis for a term loan.
While in some cases, lines of credit include all four or more asset classes, accounts receivable and inventory generally replenish themselves several times a year and collectively fall in the category of working capital financing.
Advantages and Disadvantages
Asset based lending has many benefits over traditional methods of financing. The borrowers get more liquidity and fewer financial covenants.
Other advantages include:
- Small companies can get more cash quicker than from a traditional bank loan
- Growth without creating debt
- Greater leverage
- More flexibility
- Ability to recapitalize
- Ability to take advantage of supplier discounts
- Buyout shareholders
- Fund payroll
- Fast and effective way to obtain working capital
- Do not have to give up equity
- Lender has right to seize assets and future payments upon default
- Higher interest rates
- Lending limits may be lower
- Requires audits and monitoring
- Increases the cost of funds and lowers profits
As you can see, there is no “one size fits all” approach to borrowing or lending. Businesses and lenders alike must carefully weigh the need for loans, the creditworthiness of the business, and the various options available before moving forward. If you have any questions, please contact us at 404.874.6244 or fill out the contact form below.