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Asset-based lending is a type of business financing where the borrower's assets are used as security for the loan. It differs from conventional lending, which primarily depends on the borrower's creditworthiness and cash flow. When a company needs to obtain funds fast or has few other options, asset-based lending can give it additional flexibility and liquidity.
Asset-based lending is the practice of making loans under contracts that are backed by assets. Inventory, accounts receivable, equipment, and other items that belong to the borrower may be used as collateral for an asset-based loan or line of credit. Instead of serving consumers, the asset-based lending sector benefits enterprises. Also called asset-based finance.
The primary benefit of asset-based lending is that it enables companies to use their current assets as collateral to secure money for a range of needs, including working capital, expansion, acquisition, or restructuring. Moreover, asset-based lending can assist businesses in increasing their cash flow and effectively managing their inventories and receivables.
Asset-based lending does, however, present significant difficulties and dangers. For instance, in order to meet the demands of the lender, the borrower must maintain a specific level of asset quality and value. To keep an eye on the borrower's performance and the quality of the collateral, the lender may additionally impose covenants and reporting requirements. The danger of losing the collateral in the event of default, as well as greater interest rates and costs than with conventional loans, may also be faced by the borrower.
How does asset-based lending work?
The process of asset-based lending typically involves the following steps:- The borrower submits an application to a lender, such as a bank, finance company, or private equity firm, for an asset-based loan or line of credit.
- To establish eligibility and loan terms, the lender considers the borrower's financial situation, business plan, and asset portfolio.
- The lender evaluates the quality, quantity, and value of the assets that will be used as collateral by conducting an appraisal or audit.
- Each asset type is given a loan-to-value (LTV) ratio by the lender, which represents the amount of the asset's value that can be borrowed. LTV ratios of 85% are frequently used by lenders for marketable securities, 70% for accounts receivable, 50% for inventory, and 40% for machinery, according to the Corporate Finance Institute.
- The borrowing base, or maximum amount that can be borrowed, is determined by the lender using the value and LTV ratio of the collateral. For instance, the borrowing base would be $70,000 if the borrower had $100,000 in accounts receivable with a 70% LTV ratio.
- The borrower accepts the lender's terms and covenants before receiving the loan or line of credit. Up to the borrowing base limit, the borrower may withdraw money from the line of credit.
- To make sure the collateral satisfies the established requirements and criteria, the lender periodically reviews it. Depending on changes in the market value or quality of the collateral, the lender may modify the borrowing base or LTV ratio.
- The borrower pays back the loan or credit line in accordance with the due date and interest rate decided upon with the lender. Moreover, fees for the loan's origination, administration, appraisal, audit, and maintenance may be paid by the borrower.
- Once the loan or credit line has been paid in full, the lender releases the lien on the collateral.
Example of asset-based lending
Let's use the hypothetical case of a manufacturing company that needs $500,000 to upgrade its machinery and increase its output to demonstrate how asset-based lending actually operates.
The company has machinery worth $600,000, accounts receivable worth $400,000, and inventory worth $300,000. A lender that offers LTV ratios of 50% for inventory, 70% for accounts receivable, and 40% for machinery receives an application from the business for an asset-based line of credit.
The lender appraises and audits the company's assets and verifies their value and quality. The lender then calculates the borrowing base as follows:
Inventory: $300,000 x 50% = $150,000
Accounts receivable: $400,000 x 70% = $280,000
Machinery: $600,000 x 40% = $240,000
Total borrowing base: $150,000 + $280,000 + $240,000 = $670,000
A $500,000 credit line with a 10% annual interest rate and a 5-year repayment period is approved by the lender. The business can take out money from the line of credit up to $500,000 as needed to pay for the expansion and equipment purchases.
