What Is an Asset-Conversion Loan?
An asset-conversion loan is a short-term loan that is typically repaid by liquidating an asset, which is used as collateral to obtain the loan, which is usually inventory or receivables. Asset-conversion loans are typically used by companies with highly seasonal businesses, such as those that earn most of their income around Christmas.
- An asset-conversion loan is a short-term loan that is secured by collateral that is made to a business. The liquidation of the collateral is often used as the means to pay back the loan.
- Most commonly, accounts receivables or inventory will be used as the collateral, so that when the company makes sales, portions of the revenue go back to paying the loan.
- There are scenarios where other assets are used as collateral, such as property, plant, and equipment (PP&E). In these cases, if the borrower defaults on the loan, the collateral will be seized and sold by the lender to cover the loan.
- Lenders typically require the collateral to be of high value, liquid, and have a low depreciation rate. The better the quality of the collateral, the better the loan-to-value ratio and interest rate for the borrower.
How an Asset-Conversion Loan Works
An asset-conversion loan, also known as asset-based lending, is a type of loan that is secured by collateral, which will be a specific asset of a company. The loan is ultimately paid back by the revenue generated from the sale of the asset. Common assets used in asset-conversion loans are inventory, accounts receivable, cash equivalents, and property, plant, and equipment (PP&E).
For example, a toy company may need to pay its employees in mid-November, but it is cash-poor because it has laid out most of its funds to produce and market toys that won’t be purchased until December.
One option the toy company might explore is to get an asset-conversion loan. It could take the loan while simultaneously agreeing to put a delivery truck up for sale. When the truck sells, the loan is paid off. If it doesn’t sell, the toy company will be in default on the loan, but the lender will have the truck as collateral.
Asset-conversion loans are short-term loans used when a company needs a quick infusion of cash because it has no liquidity.
Because an asset-conversion loan is secured by collateral, it is viewed as a less risky option for a lender compared to a loan with no collateral.
This benefits the borrower as it will result in a lower interest rate. Depending on the liquidity of the collateral, the interest rate will fluctuate. More liquid collateral, meaning an asset that is fairly easy to sell, will result in a lower interest rate than an asset that is difficult to sell.
For example, if a company used its shares of Apple stock as collateral, this would be fairly easy to sell than if it used its metal factory in China as collateral, which would be much more difficult to sell.
Advantages and Disadvantages of an Asset-Conversion Loan
The primary advantage of an asset-conversion loan is the quick infusion of cash that does not require a lengthy credit evaluation because the loan is secured by an asset. This results in the loan coming with a lower interest rate than an unsecured loan and fewer financial covenants that the company needs to abide by; such as meeting a certain amount of sales revenue per month.
For the lender, the advantage includes less risk because of the collateral, which, if the borrower defaults on the loan, it can sell to cover any losses.
There are a few disadvantages when it comes to obtaining an asset-conversion loan. First, when making a loan where a lender deems that a company's financials are not enough to generate revenue to pay off the loan, it will ask for collateral, hence the need for an asset-conversion loan.
A borrower will not take any collateral. For example, if the owner of a small business has a car that is 20 years old, it won't qualify. The collateral needs to be liquid, have a high value, and have a low depreciation rate.
If a business does have the right collateral, it comes at a high cost, meaning it is valued lower than its true value by the lender. The borrower will be given a low loan-to-value ratio. For example, the lender may assess the value of the collateral provided and determine that it is only willing to lend 70% of the collateral's value. If the borrower defaults, it has to "sell" its asset for less than it's worth to cover the loan.
Furthermore, if the collateral appreciates in value over time, this will not be taken into consideration for the loan amount, making the loan even more expensive.
One other disadvantage is that an asset-conversion loan does not help build a business's credit score. Most loans build a credit score as they show an individual has the capacity to pay back borrowed money; however, secured loans do not count towards this.
How Do Asset-Based Loans Work?
An asset-based loan is a type of loan in which a borrower posts collateral to obtain an infusion of cash. The collateral is typically inventory or receivables that can be used to pay off the loan. For example, a company's revenues from the sale of its inventory can be used to pay off the loan. If the borrower defaults on its loan, then the lender can seize the collateral and sell it to cover its losses.
What Assets Can Be Used as Collateral to Secure a Loan?
The types of assets that can be used as collateral to secure a loan vary depending on the amount of the loan, the borrower, and the lender. In an asset-conversion loan, the collateral will need to be of high value, liquid, and have a low depreciation rate. It will also have to be related to the business, such as property, plant, and equipment (PP&E), inventory, or receivables. In general, however, collateral can be a house, a car, cash, stocks, bonds, insurance policies, machinery, and more.
Is It Safe to Use Collateral to Obtain a Loan?
It can be risky to use collateral to obtain a loan because if you default on your loan then the borrower will seize your asset. For example, if you pledge your home as collateral for a loan and then cannot pay back your loan, the lender can seize your home and sell it to cover its losses. Loans with collateral usually result in lower interest rates for the borrower, which is beneficial to the borrower, but the borrower should be financially ready to lose the collateral if it cannot pay back its loan.