What Is Asset-Based Finance?
Asset-based finance is a specialized method of providing companies with working capital and term loans that use accounts receivable, inventory, machinery, equipment, or real estate as collateral. It is essentially any loan to a company that is secured by one of the company's assets.
Asset-based funding is often used to pay for expenses when there are temporary gaps in a company's cash flows or the usual time lag in the cash collection cycle between buying raw materials until receiving cash for goods or services from customers, but it can also be used for startup company financing, refinancing existing loans, financing growth, mergers and acquisitions, and for management buy-outs (MBOs) and buy-ins (MBIs).
Asset-based finance may also be called asset-based lending or commercial finance.
- Asset-based financing is a way for companies to use property, inventory, or accounts receivable as collateral to obtain a loan.
- Asset-based finance is a field solely used by businesses, not by individuals seeking personal loans.
- These types of loans may be more flexible than traditional commercial loans; however, the downside of this type of arrangement includes high financing costs.
- Other names for the asset-based finance industry are commercial finance and asset-based lending.
- Asset-based loan financing may be used by companies that need short-term working capital to keep day-to-day operations, like payroll, for example, up and running.
Understanding Asset-Based Finance
An example of asset-based finance would be purchase order financing; this may be attractive to a company that has stretched its credit limits with vendors and has reached its lending capacity at the bank. The inability to finance raw materials to fill all orders would leave a company operating under capacity and could put the company at risk for closure.
Under a purchase order financing arrangement, the asset-based lender finances the purchase of the raw material from the company's supplier. The lender typically pays the supplier directly. After the orders are filled, the company would invoice its customer for the balance due. The accounts receivable set up at this time would typically be paid directly from the customer to the asset-based lender.
After the lender receives payment, he then deducts the financing cost and fees and remits the balance to the company. The disadvantage of this type of financing, however, is the interest typically charged, which can be as high as prime plus 10%. However, these loans do have lower interest rates than unsecured loans because of the loan's collateral that allows the lender to recoup any losses if the borrower defaults.
Asset-based loans are agreements that secure the loan via collateral, like equipment or property owned by the borrower. Asset-based lending may be a line of credit or a cash-funded loan, but either way, the loan money is secured by some sort of collateral from the borrower's business or properties, such as inventory or accounts receivable.
The most frequent users of asset-based borrowing are small and mid-sized companies that are stable and that have physical assets of value. However, larger corporations do use asset-based loans from time to time, usually to cover short-term cash needs.
Asset-based finance lenders tend to favor liquid collateral that can be easily turned into cash if a default on the loan occurs. Physical assets, like machinery, property, or even inventory, may be less desirable for lenders. When it comes to providing an asset-based loan, lenders prefer companies with not only strong assets but also well-balanced accounts.