Asset based lending has been growing in popularity as a way to finance small and mid-sized companies. Asset based loans are easier to get than commercial lines of credit and provide more flexibility.
Initially, asset based loans were offered only to mid-sized companies – those with at least 50 million dollars (CAD) in yearly turnover. However, some asset based lenders now offer their solutions to small companies with yearly turnover as low as 5 million dollars. This development has created new financing opportunities for small businesses.
This article:
- Explains asset based financing
- Discusses advantages and disadvantages of the solution
- Provides alternatives that offer even more flexibility
What is an asset based loan?
Asset based lending is a type of funding that allows you to finance the assets of your balance sheet. Usually, companies can finance their accounts receivable, inventory and machinery. These facilities can be structured to operate like lines of credit or term loans. The structure is based on the underlying assets being leveraged.
Asset based lending facilities that are backed by accounts receivable and inventory often operate like revolving lines of credit. Your company gets to draw funds from the line up to a limit. The line settles as invoices are paid and inventory is sold off. On average, you can draw up to 80% of your accounts receivable and up to 50% of the orderly liquidation value of your inventory.
Machinery-backed lines usually have term loan structures that are amortized over a period of time. You can learn more by reading “What is Asset Based Lending?”
Advantages for small businesses
Asset based facilities can provide a number of benefits for small and mid-sized companies. The obvious advantage is that using the line can improve cash flow and help you grow the company. Furthermore, increasing the availability in an asset based financing facility is easier than increasing the availability in a line of credit. All you need are quality assets. For example, companies that finance their receivables can increase the size of their line when they sign on new customers.
Additionally, qualifying for an asset based loan (ABL) is easier than qualifying for a commercial line of credit. Your company may have to comply with certain ratios (e.g., fixed charge coverage, debt/equity, etc), but control won’t be as strict. Lastly, the application process is comparatively easy and can be completed in a few weeks.
Disadvantages
While asset based loans are one of the cheapest ways to finance assets, they are more expensive than commercial lines of credit. Therefore, ABLs cannot be used effectively by businesses that have very thin margins.
Asset based loans also require some ongoing management. Your company may need to fill out regular borrowing certificates, in which assets and liabilities are stated in detail. This certificate determines the availability of funds. Your company also needs to keep its accounting up to date and be able to provide financial reports regularly. Lastly, lines that are backed by inventory must have an effective inventory management and accounting system. Lines that include inventory financing also need to go through field exams once or twice a year to ensure compliance.
Perhaps the biggest challenge of this solution is that most Canadian asset based lenders need to keep reserves for some priority payables. These reserves limit some of the funds’ availability because they are subtracted from availability in the borrowing certificate. Reserves are usually kept for:
- Source deductions
- Union fees
- Corporate taxes
- WSIB
- Free issue inventory
Alternatives
Asset based loans are a great solution for growing companies that cannot get a conventional line of credit. However, due to their limitations, ABLs are not for everyone. Companies can often get increased availability by financing each asset independently and by using a factoring structure to finance invoices.
a) Confidential factoring for receivables
Accounts receivable can be financed using factoring financing. A factoring line can finance up to 80% (this amount varies) of your accounts receivables as long as they are payable by creditworthy customers. However, factoring is not a loan but, rather, a sale of the receivables. This small difference allows factoring companies to increase funding if necessary without having to hold any payable reserves.
Some factoring lines require that your clients be notified. However, factoring companies can offer confidential factoring lines which require minimal – if any – customer interaction.
b) Inventory financing
An inventory financing line can often be provided as an add-on to a factoring line. This solution enables you to finance your inventory, which increases your liquidity. Transactions are settled once the inventory is sold off as finished product. Inventory is usually funded at a percentage of its net orderly liquidation value. Note that this value is usually lower than market value. Inventory financing is usually more expensive than other types of financing due to risk and complexity.
c) Equipment financing
Lastly, if your company can finance any remaining equity, it can be financed through an equipment line. This solution can provide additional funds availability. Equipment financing transactions are usually structured as term loans.
Which product is right for you?
Before moving forward with an asset based loan, business owners must carefully consider their business strategy and match it to their financial objective. The most common objectives are:
- Highest funds availability
- Lowest cost
- Most flexibility
If you are looking for the absolute lowest cost outside of a line of credit, consider an asset based financing program. However, this cost advantage comes with slightly lower available funds and less flexibility than the alternatives.
On the other hand, if you are looking for the highest funds availability, try combining a confidential factoring facility with an inventory line and an equipment line. These solutions, however, have a higher cost.
Ultimately, you must weigh the benefits and make the right strategic choice for your business.
Looking for financing?
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