Asset-Based Lending

What is 'Asset-Based Lending'

Asset-based lending is a business loan secured by collateral (assets). The asset-based loan, or line of credit, is secured by inventory, accounts receivable, equipment, and/or other balance-sheet assets.

Asset-based lending is also known as commercial finance or asset-based financing.

BREAKING DOWN 'Asset-Based Lending'

Businesses usually take out loans to meet various cash flow needs of companies, for example, meeting payroll or building inventory. When a company cannot show that it can pay for a loan through its cash flows, the lender may decide to approve the loan based on the value of the entity’s assets. This form of business financing is referred to as asset-based lending.

Asset-based lending occurs when a loan is granted to a firm solely on the value of assets pledged as collateral. The terms and conditions of an asset-based loan depends on the type and value of assets offered as security to the lender. Lenders usually prefer highly liquid securities that can readily be converted to cash in situations where the borrower defaults on its payments. In general, the more liquid the pledged asset, the higher the loan-to-value ratio. In addition, loans that are granted under asset-based financing are never the full value of the assets pledged.

For example, say a company seeks $200,000 in loan to expand its business operations. If the company decides to pledge its highly liquid marketable securities on its balance sheet as collateral, the lender may grant 85% of the face value of these assets. This means that if the firm’s marketable securities are valued at $200,000, the lender will be willing to loan $170,000. If the company, however, chooses to pledge less liquid assets such as real estate, finished inventory, or equipment, it may be only to secure only, say 50% of its required financing.

Interest rates on these loans, as you can imagine, are less than interest rates on an unsecured loan or line of credit because if the borrower defaults, the lender has the ability to seize assets and sell them in an attempt to recoup its lending costs. The lender's interest is secured by the assets of the borrower which also determines how large of a loan a company can access. The interest charged on an asset-based loan is determined by the size of the loan, and ranges from 7% to 17%, expressed as an annual percentage rate (APR).

Companies go through the route of asset-based lending for a number of reasons. The cost of issuing shares or bonds in the capital markets may be too high. A firm may also not be able to raise capital through the securities market if it needs immediate funding for a time-sensitive project such as a merger, acquisition, inventory purchase, etc. Also, if getting unsecured financing proves to be challenging, a business may opt for asset-based lending. Companies that take asset-based loans usually have cash flow problems that stem from rapid growth. Small and mid-sized companies that are stable and that have assets to be financed are common asset-based borrowers.

The assets used in asset-based lending are not normally pledged as securities for other loans. If they are pledged to another lender, the other lender must agree to subordinate its position.