Project Management

Can Your Assets Raise Cash?

There is an industry out there in these United States of America that is $314 billion strong. It includes all sorts of manufacturers, wholesalers, retailers and financial institutes. And it plays a vital part in financing the economy. Do you know it?


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It is Asset Based Lending. Asset-based financial service organizations provide operating cash, funding for acquisition, money for operations and financing for reorganization to small, medium and large organizations of all sorts in all types of industries. These organizations include the asset-based lending arms of domestic and foreign commercial banks, small and large independent finance companies, floor plan financing organizations, factoring organizations and financing subsidiaries of major industrial corporations.


In a previous feature, we looked at creative ways to finance a business initiatives. Another such method is Asset-Based Lending (factoring is a type asset-based lending mechanism). Like factoring, it too is a big industry and is one of the most popular methods of securing commercial-industrial short-term credit. According to the most recent survey by the Commercial Finance Association, close to 25 percent of all new short-term financing was provided by asset-based lenders. More than 60,000 U.S. companies make use of asset based loans--31 percent manufacturers, 28 percent wholesalers and 17 percent retailers. More than 71 percent of these businesses are small businesses with less than $50 million in sales.


It Finances Operations
An asset-based loan is a type of secured loan that is usually secured against a collateral, which could be account receivables, or inventory or equipment, or real estate or other tangible assets that do not have any primary liens against them.


Two types of credit facilities are typically used to extend asset based lending (ABL)--working capital and fixed asset. Working capital facility is mainly based on account receivables and/or inventory. These types of loans are mostly revolving lines of credit without a scheduled repayment. In this case, the lender extends credit to the borrower to carry account receivables and inventory. The loan is paid when such assets are converted to cash.


The second type of facility is fixed asset, which is used to finance equipment and real estate. These are transactional debts and typically have fixed scheduled repayments that cover the useful life of the asset. They may carry a higher degree of risk than revolving debt and are normally provided by equipment finance companies, leasing companies and mortgage bankers.


Though any company with asset could obtain ABL, typical asset-based borrowers are manufacturers, distributors or service companies that have heavy investments in assets and thin capitalization. They may be in cyclical industries or their cash flow may have strong seasonality.


It Could Help You Grow
As compared to many other financing alternatives, asset based loans are quite flexible and cost competitive. Many businesses use them because they provide greater operational flexibility. The good candidates for ABL are the companies that have tangible or cash-generating assets, such as accounts receivable, inventory, equipment and real estate. These companies would be "asset-heavy" as compared to "cash-flow rich." They also may have high-leverage ratios--a debt-to-equity ratio of over 5 to 1--or they may have a recent history of losses or may have inconsistent cash flow. These companies also may have trouble obtaining credit due to the changing economic times.


Asset based loans address short-term financing needs that may include operating cash, funding for an acquisition, debt consolidation, turnaround financing, bankruptcy/reorganization financing, equipment financing, inventory financing, floor plan financing, equipment leasing, import/export trade financing, growth financing, factoring services, etc. It could be used when the operating cash is tied up in receivables or when the best trade terms for supplies create cash flow shortages. It could be used when inventory levels are high because of client demands and the sales growth strains resources.


Relying on Operating Performance
These loans rely less on the borrower's operating performance as compared to the cash-flow loans and focus more on the collateral's cash conversion cycle for repayment. The covenants attached to these loans are also mainly concerned with the borrower's asset coverage, liquidity and the ability to service debt. By contrast, cash flow loans have more stringent financial covenants that include maximum leverage ratio allowed, fixed charge coverage, interest coverage, minimum EBITDA, minimum working capital, etc.


As these loans use tangible assets as collateral, the lender qualifies the borrower for loan based upon the quality, liquidity and sufficiency of the borrower's eligible assets. Before extending a loan, the lender performs the liquidation analysis of the asset to determine its net realizable value, which puts the upper ceiling on the loan amount.


Apart from quality, liquidity and sufficiency analysis, the lender also puts control and monitoring requirements. These loans also require ongoing loan monitoring and reporting of account receivable, inventories and fixed assets. This could be quite time consuming and effort intensive. In fact, before computers became so ubiquitous, reporting requirements were one of the reason for high cost of service of ABL. The technological developments have made reporting much easier and less costly.


The level of controls and monitoring is directly related to the credit worthiness of the borrower. The reporting details sought also may vary. The controls may be administered daily, weekly or monthly. A ratio that is regularly monitored is the value of the collateral to the actual balance of the loan. Other controls may cover sales invoices, shipping documents, account receivable aging, inventory details, etc. The lender may also require control over cash by establishing a collateral account into which accounts receivable collections are deposited. The access to this account maybe restricted to the asset-based lender.


Apart from this, the lender may perform ongoing audits that may look into the borrower's books and records to check the accuracy and validity and to substantiate collateral values as represented by the borrower.


Would It Work for You?
Even though many still think it to be the last resort for commercial borrowers or an expensive financing option with excessive reporting burden, ABL does provide a number of advantages.


The pricing of ABL is also generally more competitive than a secured cash flow loan. It improves the liquidity position of a company, especially for one within a cyclical industry borrowing against assets that may provide more financial stability as compared to borrowing against the cash flow.


ABL also instills discipline. As the loans are based upon account receivables, the borrower would be more motivated to improve collection. Another aspect is that the work-in-progress is generally ineligible for collateral, which means that the borrower must increase efficiency to increase liquidity.


As mentioned earlier, ABL imposes less stringent covenants compared to cash flow loans. These loans also provide a much better security to the lenders, which may allow them to give more time to the borrowers to turn around their company in difficult financial times.


On the flip side, ABL does have a few disadvantages for borrowers as well as lenders. The level of actual funding is dependent upon the assets on the balance sheet, such as receivables, inventory, and equipment, which may not provide the sufficient liquidity. The quality of assets may also adversely affect the rate and availability. Another additional expense for both lender and borrower is the greater reporting requirements and monitoring of assets.


The asset-based loans have been around for some time. Couples of decades back, only the riskiest of companies were borrowing against assets. Now a broad range of companies is using ABL with good results. Back then the competition amongst lenders was less too, which made it a costly way to finance the business. Since then the high interest margin has prompted more financial institutes to enter the market dropping the cost of loan service. This has made ABL cost competitive. However, despite many direct and indirect benefits, borrowers should assess the cost of financing in the context of overall payback to the business.


Strategic and results-oriented, Sunil is an entrepreneurial consultant who had founded a B2B ASP for the building & construction industry. His area of expertise includes strategic management, marketing and business planning for high-tech firms. He publishes a business and marketing planning e-newsletter. An avid mountain climber and runner, Sunil has climbed Mt. Kilimanjaro and various peaks in the Himalayas, and finished the Detroit marathon. He holds an MBA degree from the University of Michigan, Ann Arbor, and a BS in Electronics and an MS in Mathematics from the BITS, Pilani, India. He can be reached at (703) 395-9812 and at [email protected].

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