Companies seeking financing to maintain and grow their business will often look first to traditional unsecured bank loans, since that is usually the least costly form of borrowing available.
However, many small businesses are either:
- Growing rapidly,
- Do not have a lengthy track record; or
- Do not have a sufficiently high credit rating
As a result, these businesses are often turned down for a traditional bank loan. This has been especially true in recent years following the financial crisis, after which lenders have become more cautious in their loan approvals.
Often, too, some businesses that already have bank lines of credit cannot obtain additional funds from the bank, since the bank will not extend additional credit beyond the current limit. Thus, the bank will not finance their further growth.
So, what is a company to do when customer receivables fall 60 to 90 days or even longer beyond their due date, and the company is left with a significant shortfall in working capital? In such situations, businesses can seek another form of financing, like asset-based lending (ABL), which may meet the business’s need for additional financing.
What are the differences between asset-based lending and traditional lending?
ABL provides a much more flexible approach to financing a business’s current operations and needs for future growth. In contrast to traditional bank lending, where the borrowing company’s operations are evaluated and its future cash flow is projected, asset-based loans are based on the collateral put up for the loan. The most typical type of ABL is made against the business’s accounts receivables. Here, the lender advances funds to the borrowing business based on the value of the receivables submitted to the lender. Typical advance rates are in the range of 70 percent to 90 percent. The creditors submit payment to the lender, and when the funds are collected, the lender provides the balance to the borrower, minus the fees it charges for the loan and for managing the collections process.
An asset-based loan typically takes the form of a revolving line of credit, which is refreshed when the collateral, e.g., the receivables, are paid down. While asset-based lenders also lend against other types of assets, including inventory, capital equipment, and real estate, receivables are frequently the largest proportion of collateral for these loans, largely because of their greater liquidity.
The lending process
Asset-based lenders focus on the quality of the collateral rather than on the borrower’s cash flow or credit rating. They evaluate the creditor’s ability to make payment and their track record of past payments to determine their credit-worthiness. Traditional bank lenders are constrained by internal bank lending standards.
For example, banks typically will not lend to companies that have debt-to-capital ratios greater than four or five to one. By contrast, independent asset-based lenders are not subject to such constraints, giving them the freedom to finance many small businesses that are thinly capitalized or otherwise do not meet traditional bank lending standards, but that are good businesses with bright long-term prospects.
Benefits of ABL to the borrower
Borrowers benefit from asset-based loans in a variety of ways. ABL provides immediate and on-going cash flow liquidity for a company’s working capital, including the purchase of materials and supplies, the ability to meet seasonal requirements, to meet payroll and other operating expenses and to keep their accounts payable current.
While a bank’s lending process may be lengthy and cumbersome—taking up to several months in some cases as the bank analyzes the borrower’s financial statements, credit history, and generally the entire business—asset-based lending requires comparatively less time to conduct the transaction. Further, because ABL loans are based on collateral, lenders are more often willing to be much more flexible and work with a borrower during a period of financial difficulty when the company’s finances are stretched.
Since asset-based loans don’t rely on the borrower’s operating performance, but on the quality of the collateral, fewer financial covenants are required of the borrower, and as compared with traditional bank lending, ABL lenders typically require a much more limited degree of reporting back to the lender.
While determining your borrowing strategy should be individualized based upon each business and tailored to your business’s specific needs, borrowers seeking working capital financing need to seriously consider the benefits of working with an asset-based lender, as it can provide greater flexibility and options for businesses seeking to look beyond traditional bank lending. Share which lending strategy has worked best for your business in the comments below.